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Add Stock Buybacks to the Causes of the Market Downturn

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(Bloomberg Gadfly) -- There's a new reason to dislike stock buybacks: They contributed to last week's market downturn.

Some market watchers are adding corporate share repurchases to the list of reasons for last week's turmoil, which already included rising interest rates, higher inflation, growing government debt, volatility-linked investment funds and Washington instability. More significantly, those pointing the finger at buybacks say continued corporate stock purchases -- which, unlike some of those volatility funds, survived the brief market downturn -- will make the next one far worse.

Here's the logic: Companies over the past decade or so have significantly increased buybacks to the point where they are now collectively the largest single buyer of stocks. Some have called the market self-cannibalizing. Equity shrink is the nicer way to say that.

Corporations are not particularly price sensitive -- buybacks tend to rise with the market -- but they do try over short periods to buy at the lowest average price. So in a long bull market, like the one we are in now, corporations tend to step in to buy whenever there is a dip, which is what happened last week. Goldman Sachs, for one, said that its unit that executes share buybacks received a surge of orders last week.

All that buying insulates the market against drops, which causes volatility to drop. Lower volatility causes humans to think stocks are safer than they are and computers to actually calculate that. Everyone piles into stocks, which lowers volatility further, until there's a big blow-off like last week. "Stock buybacks are in effect creating low volatility," says Christopher Cole, a hedge fund manager who has been warning that volatility has been artificially and dangerously depressed for a while. "Share buybacks are like a giant synthetic short-volatility position."

Of course, critics have accused stock buybacks of skewing the market before. The complaint is typically that buybacks funnel money back into the market instead of into more productive uses, which artificially inflates stock prices and draws in even more investment, again presumably away from other more productive uses. It's not clear when the buyback influence on the market tips over into a crash. Also, not everyone agrees that buybacks reduce volatility. Here's a paper that suggests, at least when it you look at individuals stocks, and not the market as a whole, it does the opposite.

Vineer Bhansali, the chief investment officer of LongTail Alpha, who has warned about the volatility bubble, says that buybacks can suppress volatility for the right reasons. When companies produce more cash than they can productively reinvest in their businesses, they buy back stock, lifting prices and curbing volatility. The problem, as has increasingly been the case, comes when companies fund buybacks by taking on more debt rather than with the cash generated by their operations. That's when repurchases become part of the leveraged low-volatility trade that can unwind disastrously when interest rates rise. 

The counterargument is that buybacks are no different from stock purchases that take place after Wall Street strategists go on television and tell investors to buy on the dips. Warren Buffett does it all the time, though you would hope Buffett tells people to buy stocks when they are actually cheap. (Also, "buy stocks" is basically always his advice.)

On some level, this is human nature. We are all unfortunately more momentum investors at heart than Warren Buffett. So we buy vigorously on the way up and run for cover on the way down, which creates low-volatility bubbles and high-volatility crashes. Buybacks most likely contribute to that and may be having an outsized influence right now. Some have suggested taking steps, like changing the tax treatment, to effectively discourage buybacks. Curbing buybacks won't end bubbles or market crashes, but understanding their role can make them an early warning signal. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Stephen Gandel is a Bloomberg Gadfly columnist covering equity markets. He was previously a deputy digital editor for Fortune and an economics blogger at Time. He has also covered finance and the housing market.

©2018 Bloomberg L.P.

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