Goldman: Expect Higher Volatility As “Buybacks Won’t Return For Weeks”


So far this earnings season, 17% of S&P companies have reported, with 57% beating on EPS and 48% beating on revenue.

The strong corporate numbers are hardly a surprise: as we previewed 2 weeks ago, as a result of Trump’s tax reform and rising oil prices, Wall Street has been expecting blowout numbers…

… and if anything, the risk was for disappointment, as most of the banks have experienced first hand (whereas 65% of the Financials stocks beat on earnings, the median stock trailed the S&P 500 by 21 bp amid fears about loan growth and trading activity). And considering that the S&P is unchanged for the year as of Friday’s close, it is safe to say that the blockbuster earnings season was fully priced in.

There is also another, more explicit reason why stocks have been unable to catch a sustained bid during much of earnings season: as Goldman’s David Kostin writes in his latest Weekly Kickstart, 80% of S&P 500 firms are currently in their buyback blackout windows, meaning they generally avoid – but are not prohibited from – repurchasing stock. Furthermore, April is one of the weakest months for the buyback basket, as share repurchase spend is extremely low during the blackout window.

While this clearly has an adverse impact on stock prices, it also impacts volatility, because according to the reports, “since 2000, volatility has typically been higher during blackout periods compared with non-blackout periods given the absence of corporate demand to support share prices.”

The flipside is that the “blackout” period will end shortly, when the bulk of companies report earnings over the next 2 weeks. What happens then?  There are two answers.

Buybacks over the short term

When looking at the rest of 2018, Goldman is especially optimistic, predicting that when the blackout window reopens, it expects buybacks to resume their YTD strength “and rise by 23% year/year to $650 bn in 2018” driven by strong corporate cash flows and the one-time tax on overseas cash which has freed up a pool of capital for potential shareholder returns. As a result, Goldman’s derivatives strategist also notes in addition to buybacks, economic conditions also suggest volatility should be lower than current levels over the near-term.

Furthermore, as noted before, the Goldman buyback desk reported recently that it has witnessed a substantial acceleration in client activity YTD (+62% year/year), having recently experienced its most active day in history. In specific terms, S&P 500 buyback authorizations YTD have totaled $205 billion, representing a 48% jump vs. the same point in 2017.

Goldman makes another notable observation, one which may explain why the Nasdaq continues to roar ever higher: for the first time, it is the Info Tech sector that has led the S&P in buybacks, with $90 billion of buybacks in 2018, representing 44% of the S&P 500 total.

And with Trump’s tax reform implicitly encouraging buybacks, it is not surprising that firms have recently expressed a preference for buybacks over dividends: “Dividend payout ratios are lower than history at 35% and we forecast S&P 500 dividends per share will grow by 10% in 2018.”

Buybacks over the longer term

Where things get complicated is what happens to buybacks as we enter 2019. According to Kostin, the outlook for buybacks in 2019 appears far less constructive, if not outright gloomy:

We expect cash flows available for buybacks will be smaller than in 2018, as companies lose some of the one-time boost from tax reform, economic growth slows (2.7% to 2.2%), and EPS growth decelerates (12% to 5%). Furthermore, there will be heightened scrutiny regarding how firms are spending the incremental profits that result from lower corporate tax rates.

There are also political considerations, as the midterm elections take place just as we enter 2019, and could lead to a dramatic change in the political arena: On one hand, share repurchases can be an appropriate use of cash if surplus capacity exists and firms lack productive capital investment opportunities. On the other hand, additional profits from tax reform could also be allocated to employees through higher compensation.

And, as Goldman points out, “wage growth appears to be a key issue for Democrats as we approach the midterm elections” resulting in further political pressure weighing on the popularity of share repurchases in 2019.

* * *

What does all of the above mean for stocks?

Somewhat surprisingly, Goldman finds that stocks returning cash to shareholders have lagged the S&P 500 since the 2016 election.

Although cash return strategies have a long-term track record of outperformance, our sector-neutral basket of stocks with the highest combined buyback and dividend yield (GSTHCASH) has underperformed the S&P 500 by 2 pp while firms with the highest trailing buyback yield (GSTHREPO) have essentially matched the broad market since the election. We expect cash return strategies will continue to lag going forward as interest rates rise and yield-based strategies become less attractive.

Two further observations from Kostin, even if recent events suggest these may have been somewhat arbitrarily reached. First, Goldman calculates that investors have preferred growth-oriented cash return strategies…

Our dividend growth basket (GSTHDIVG) consists of firms offering both high dividend yield and strong expected dividend growth. This sector-neutral basket outpaced the index by 4 pp during 2017 and has matched the S&P 500 YTD.

… and second, the bank expects investors will reward firms prioritizing investing for future growth, a basket Goldman tracks under the GSTHCAPX ticker.

Our basket contains 50 stocks with the highest capex and R&D spend as a share of market cap. During 2017, the basket outperformed the S&P 500 by 10 pp although it has trailed the market by 1 pp YTD. Companies focused on capex in 2018 are well-positioned to deliver future growth and are scarce compared with stocks returning cash to shareholders. Firms investing in capex and R&D tend to outperform during rising interest rate environments, which is our forecast for 2018.

Besides chasing buybacks, however, companies are putting up all the recently released cash to use in yet another form of corporate activity: M&A. Here, as Kostin points out, the outperformance of potential M&A targets in 2018 has stood out relative to other use of cash strategies.

US acquisitions surged in 1Q 2018 to $473 bn (+66% year/year), the fastest start on record (see Global Markets Daily: M&A is off to a record start, April 9, 2018). The M&A target basket (GSRHACQN) consists of stocks estimated by GS analysts to have at least a 15% likelihood of being acquired in the next 12 months. The basket has outpaced S&P 500 by 4 pp YTD alongside the recovery in M&A. Continued growth in M&A activity should support the  performance of the basket and lift the relative P/E premium toward its high of 55% in 2013, compared with a 27% premium today.

And while all of the above sounds intuitive, there is one major flaw to Kostin’s argument, which appears to have made its way all the way to Goldman’s board room.

Recall that in the first few minutes after Goldman reported it dramatic earnings beat last week, the stock surged. However this quickly reversed when during the earnings call, management said it expects to put share buybacks during the second quarter on hold and use profits to support future investments. What happened next was a sharp drop in the stock price to session lows as investors suddenly questioned where, in lieu of buybacks, would marginal demand come from.

Perhaps the market is not quiet as ready to reward the lack of buybacks as Goldman believes.

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