What Will Trigger the Next Stock-Market Rally?

Laurence Fink, chief executive officer of Blackrock Inc., the world’s largest money manager with more than $4 trillion in assets, recently issued a warning to U.S. companies: Stop focusing on short-term returns at the expense of longer-term investments.

“It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies. Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks.”

Fink made these comments in a letter to the CEOs of the companies in Standard & Poor’s 500 Index, referring to stock buybacks and dividends as a form of “short-termism.”

What were the longer-term investments he suggested? “Innovation and product enhancements, capital and plant equipment, employee development, and internal controls and technology.” I find it hard to disagree with him.

Stock buybacks and cash dividends totaled $214.4 billion in the fourth quarter of 2013. That is the highest level since the record high of $233.2 billion in the final quarter of 2007, according to the Wall Street Journal. Compare that to the second quarter of 2009, when buybacks and dividends totaled a mere $71.8 billion.

Buybacks tend to boost per-share earnings as corporate net income is applied to a smaller base of stock outstanding. Higher earnings per share can justify an increased stock price. In an era of low bond yields, dividends are an income stream that also gives the investor potential capital appreciation.

Both of these forms of financial engineering have helped to drive U.S. equity prices higher. However, unless a company wants to go private, it can’t buy back its stock forever. Dividends are limited by a company’s earnings.

Companies only have a finite amount of cash to invest. Whatever gets spent on buybacks and dividends is that much less available to be spent on investments in employees, research and development, and capital expenditure. It’s basic arithmetic.

When will the next round of capital investment begin in earnest? As soon as you figure out the answer to that question, you will have gained significant insight into the direction of the economy as well as the next phase of this stock-market rally.

 

Originally published here

 

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