The Great Deformation

by David Stockman

  But there is another reason why CEOs capitulate and feed the beast. They are not operating on a level playing field, whether they know it or not, due to the Greenspan-Bernanke Put. It provides the speculative marauders who dominate the stock market cheap downside insurance against a big drop in the broad market averages, such as the S&P 500.

  On the free market, of course, there would be no Greenspan-Bernanke Put, meaning that the cost of an honest to goodness put on the S&P 500 index would be far higher than prevails in the Fed-sponsored casino today. Since most speculators—whether big-name hedge funds, trend-following mutual fund managers, or home gamers who are prudent enough to stay solvent—must continuously buy downside protection to remain in the game, the problem is obvious: the cost of market-priced downside insurance would consume much if not all of their winnings from piling on the momentum raids.

  At the end of the day, the Greenspan-Bernanke Put is a profound distortion of the free market. In this case, it induced one of the great progenies of American capitalism to essentially commit financial hara-kiri. Still, the looting of Hewlett-Packard was all in a day’s work in the Wall Street casino.

  BIG BLUE: STOCK BUYBACK CONTRAPTION ON STEROIDS

  IBM’s huge share buyback program, by contrast, shows that financial engineering does not always produce such immediate untoward results. Yet it is nonetheless a dramatic illustration of how the Fed’s bubble finance régime enables companies to literally “buy” themselves a higher stock price, at least temporarily, by plowing massive amounts of cash into share repurchases, thereby creating the false impression of robust earnings growth.

  Big Blue’s reported earnings thus surged 16 percent annually from $7 per share in 2007 to $13 in 2011, but those results were not apples to apples by any stretch of the imagination. The company’s stock buyback program reduced its net share count by 22 percent, and profits on its massive overseas operations had been artificially boosted by a double-digit decline in the dollar. IBM’s reported results also reflected a 12 percent reduction in its tax rate and $16 billion of acquisitions, all highly accretive mainly because they were financed with ultra-cheap long-term debt.

  In the absence of these one-timers and financial engineering maneuvers, however, the picture was not so buoyant. Based on organic revenues, constant exchange rates, and no reduction in tax rates and share counts, earnings per share grew by about 5 percent annually, not 16 percent, over the past five years. It is far from evident, therefore, that IBM’s true mid-single-digit growth rate justified the doubling of its share price during the period.

  Upon closer examination, in fact, IBM was not the born-again growth machine trumpeted by the mob of Wall Street momo traders. It was actually a stock buyback contraption on steroids. During the five years ending in fiscal 2011, the company spent a staggering $67 billion repurchasing its own shares, a figure that was equal to 100 percent of its net income.

  This massive and continuous stock-buying program brought approximately 550 million, or 36 percent, of the company’s 1.5 billion of outstanding shares into its treasury, but needless to say, they did not all stay there. Nearly two-fifths of these shares reentered the float, mainly to refresh the management stock option kitty.

  It goes without saying that in this instance the interests of stock traders and top management were aligned—perversely. The steady, deep shrinkage of the IBM float kept a bid under the stock and thereby delivered a “perfect” price chart, rising almost continuously from $100 to $200 per share over the past five years. It was a carry trader’s dream.

  Likewise, top executives got big-time pay packages they may or may not have deserved, but in any event they were dispensed in envelopes marked “tax once over lightly.” Former CEO Sam Palmisano, for example, cashed out $110 million worth of stock options a few weeks after his retirement party.

  This rinse-and-repeat shuffle of stock buybacks and options grants is undoubtedly a significant source of left-wing jeremiads about executive pay having gone to three hundred times the average worker’s compensation when, once upon a time, allegedly, the ratio was more like 30 to 1. But the issue is not simply whether this kind of financial engineering has contributed to the sharp tilt of income flows to the top 1 percent in recent years. There can be little doubt, on the math alone, that it has.

  The more crucial question, in this instance, is whether the massive CEW evident in IBM’s numbers is setting up another of the great iconic American companies for a fall sometime down the road, similar to Hewlett-Packard. The data on this score are not encouraging. Total shareholder distributions, including dividends, amounted to $82 billion, or 122 percent, of net income over this five-year period. Likewise, during the last five years IBM spent less on capital investment than its depreciation and amortization charges, and also shrank its constant dollar spending for research and development by nearly 2 percent annually. Neither of these trends is compatible with staying on top in the fiercely competitive global technology industry.

  Most especially, however, IBM’s earnings—like nearly all the big cap global companies—could not be flattered permanently by the Fed’s bubble finance. Already, the plunge of the euro has taken a toll on the company’s reported results, causing the artificial translation gains it booked on its huge European businesses during the weak dollar cycle through 2011 to now unwind. Indeed, with nearly two-thirds of its sales outside the United States, the company’s sales are now actually falling in dollar terms, and will likely continue to do so for the indefinite future.

  THE WORST $225 BILLION DEAL EVER

  In many cases, financial engineering did not work out so well for either management insiders or Wall Street speculators. One such example is Time Warner Inc.’s ill-starred merger with AOL, which was announced just in the nick of time to perfectly top-tick the dot-com mania in January 2000.

  Needless to say, the path from there had been an extended sojourn on the downside, with the company’s post-AOL market cap dropping from a peak of $225 billion to only $20 billion. Soon after the merger, AOL Time Warner set a corporate record that still astounds; namely, the $100 billion net loss it recorded in the single year of 2002.

  This financial bone-crusher triggered a continuous corporate exercise in “demerging” the discordant parts and pieces that had been accumulated by the Time Warner acquisition machine during the two decades prior to AOL. These spin-offs included books, music, magazines, cable, the Atlanta Braves, and much else. AOL itself was ultimately cast out of the fold.

  By early 2006, the stock price had dropped from a peak of $228 to $65 per share, but Wall Street financial engineers had not yet completed their work on the corpse. At that point a group of raiders led by Carl Icahn forced the company into a further restructuring plan under which it divested still more of its historic M&A spree, absorbing deep write-downs from the destruction of value it had accomplished during the holding period. Accordingly, Time Warner recorded cumulative net income of just $5 billion on sales of $200 billion during the six-year period through fiscal year 2011. Even as the net income line came up punk, however, the company did undertake $26 billion of stock buybacks pursuant to the financial engineering deal with Icahn.

  Having essentially no cumulative earnings during this period, Time Warner therefore funded the buybacks by continuously shrinking. Annual revenues of $46 billion in 2007 fell to $29 billion by 2011, and EBITDA was reduced from $14 billion to $7 billion. This drastic downsizing was a rational antidote to the thirty years of feckless M&A, but despite all of the demerging and $26 billion of stock buybacks, value could not be created were none had really existed. By the end of 2011, Time Warner’s stock price was $35 per share—down by 85 percent from the Greenspan Bubble high of January 2000.

  THE DECAPITALIZATION OF THE FORTUNE TOP 25

  This drastic decline is often cited in condemnation of the AOL merger as the worst M&A deal of all time. Most surely it is that, but the prolonged unwinding of the whole edifice of AOL Time Warner Inc. also exposes the shaky financial
engineering foundation which underpinned the faux prosperity of the Greenspan bubble era.

  As the bubble reached its final peak in 2007, financial TV reported what sounded like healthy corporate earnings and stock prices at all-time highs. But the underlying data told another story. As shown below, what was being reported as “earnings ex-items” vastly exaggerated true profitability. At the same time, the American economy was being decapitalized by rampant financial engineering. Cash was not flowing toward productive investment and growth—not in the slightest.

  This was starkly evident in the manner in which the largest twenty-five companies on the Fortune 500 list disposed of their fulsome earnings. Their net income aggregated to $242 billion during 2007, but only 15 percent ($35 billion) of that hefty total was reinvested in their own businesses; that is, allocated to additional capital expenditures and other working capital after funding depreciation and amortization of existing assets.

  By contrast, these same twenty-five companies—which included a medley of giants from Wal-Mart to ExxonMobil, AIG, Home Depot, JPMorgan, Philip Morris, and AT&T—invested nearly $345 billion in financial engineering and shareholder distributions. This stupendous total represented 140 percent of the aggregate net income of these leading companies.

  These sharply contrasting numbers spoke volumes about the financial priorities in corporate America. These giant companies effectively elected to send ten times more cash outside of their corporate walls for acquisitions, stock buybacks, and dividends than they invested in growth of fixed and working capital inside their current operations.

  To be sure, stockholders are entitled to a share of profits, and the Fortune Top 25 did distribute $90 billion in dividends, or nearly 40 percent of net income. The distortion lies in the fact that they also spent an additional $250 billion on stock buybacks and M&A deals—or more than 165 percent of net income after dividends. So they had to borrow $100 billion to fund their massive stock buybacks and M&A deals, and that was the rub. While there is no reason to believe that dubious financial engineering projects of this scale would have passed muster on the free market, it is virtually certain that rational executives and boards would not have borrowed $100 billion to try.

  Unbalanced taxation plus the Fed-enabled stock market casino and cheap debt had thus taken a profound toll. The stock averages implied that an era of unparalleled prosperity had descended on the nation, but everywhere stood signs suggesting that what had actually descended was a riot of reckless speculation on Wall Street.

  GE’S ROUND TRIP TO NOWHERE ON THE WALL STREET MOMO TRAIN

  One sign that the Fed’s “wealth effects” levitation strategy has delivered the stock market over to marauding bands of speculators is the violent “ramp jobs” that they have done on General Electric’s stock price over the last fifteen years. This roller-coaster history is totally out of character with GE’s stolid corporate persona.

  General Electric remains a tightly run conglomerate that spans a vast cross-section of both the domestic and global economy. Its vast earnings power together with its AAA credit rating makes it the epitome of a blue chip corporate giant, synonymous with gravity, reliability, and constancy. Yet owning GE’s stock over the last two decades has been more hazardous for the average investor than dabbling in the pink sheets.

  Contrary to the periodic bouts of Wall Street storytelling about GE’s credentials as a “growth stock,” the astonishing reality is that it has been just the opposite: a veritable “no growth” stock. When the maestro experienced his irrational exuberance moment in December 1996, GE traded at $17 per share. At the end of 2011, it also clocked in at $17 per share.

  Still, the fact of zero appreciation over fifteen years is not actually the hazardous part of the story. During its long round trip to nowhere, GE’s stock resided on the Wall Street “momo train,” enduring such violent thrills and spills as would have induced vertigo in the average investor.

  The first four-year ramp during the Greenspan tech bubble elevated GE’s $17 stock to $60 per share by mid-2000. Traders and speculators were gifted with a “four-bagger” over four years. During the following twenty-four months, however, the stock came crashing back to earth, settling at $23 per share in early 2003. A 60 percent stock price meltdown is supposed to happen to high-flying newcomers, not hundred-year-old, well-run diversified blue chips.

  The next ramp job, which coincided with the second Greenspan bubble, also took four years to unfold, and its peak $42 share price in September 2007 amounted to roughly a two-bagger. The subsequent cliff-diving phase was quicker and more violent, however. When GE’s stock price reached bottom in March 2009, it was a smoldering ruin at $10 per share, meaning that it lost 75 percent of its value during the second plunge of the momo train.

  Presently, the third ramp job got under way as the Fed ignited the Bernanke bubble and propped up GE’s teetering finance company with a $30 billion bailout loan. This time the ramp job was even more flaccid: by the end of 2011 GE’s stock price was still struggling to get back to the $17 per share threshold it had first crossed in December 1996.

  This roller-coaster ride on the Wall Street momo train happened, of course, precisely because there is no honest free market in the financial system. In fact, a giant company with the underlying earnings consistency of GE would not suffer consecutive 60 percent and 75 percent stock price plunges within the span of a decade on the free market. The reason for these aberrations is that the ramp jobs preceding each plunge were artifacts of the stock market deformations fostered by the Fed.

  The Greenspan-Bernanke Put has made downside insurance too cheap for the marauding gangs of professional (and some day-trading) speculators. It does not take even an amateur chart specialist to see that during the nearly uninterrupted four-year ascent of each ramp job, it would have been possible for traders using options and leverage to garner prodigious returns, even after collaring market risk with “cheap” S&P puts.

  Each time the market-wide Greenspan bubble finally collapsed under its own weight, it was the well-insured Wall Street speculators who lived for another day. The naked and the naïve, of course, got carried out on a stretcher, more often than not by way of Main Street.

  Arguably, GE’s first moon shot was owing in part to the solid profit performance of the Jack Welch years; but in the main it was attributable to the wild and unsustainable expansion of market-wide PE multiples, including GE’s 40X multiple, which occurred during the Greenspan stock mania of the late 1990s.

  After GE’s valuation multiple had been brought down to earth in 2001–2003, however, the next ramp job would never have happened on the free market. This new ramp was due to the company’s unabashed and reckless financial engineering games, maneuvers which lured more and more speculators onto the momo train—some with protection, others not.

  Again, the issue is not just about how much upside the 1 percenters scalped and how much downside the home gamers endured, although undoubtedly the computations would not be pretty. The problem is that, as detailed below, GE’s financial engineering gambits have been so extreme and extensive during recent years that they will badly impair the company’s future prospects.

  The potential for significant future impairment is suggested by the magnitude of GE’s financial engineering spree in 2007, a catalyst which helped goose its stock price to that year’s $42 peak, which was 20X the company’s trailing EPS as filed with the SEC. Even if that earnings number had been sustainable, which it wasn’t, 20X was a decidedly sporty multiple for a conglomerate consisting overwhelmingly of old-line industrials like white goods, jet engines, plastics, light bulbs, generators, and locomotives, as well as the huge but potentially volatile finance business.

  GE’s finances, however, were not on the level. During fiscal 2007 it posted net income of $22 billion, but it actually spent the rather stupendous sum of $48 billion attempting to pump its stock price and expand its asset base. This included $25 billion for buybacks and dividends, $17 billion on M&A, and $8
billion on fixed-asset acquisition on top of recycling its depreciation charge back into capital spending.

  It did not require great financial acumen to see that even an AAA company could not spend two times its net income for long. In fact, eighteen months later GE’s net income had fallen by 50 percent, its stock price was below $10 per share, and its CEO had begged for and received a massive government bailout of GE Capital’s wobbly finances.

  GE’s financial filings, in fact, screamed with warnings that its highly engineered EPS was not remotely worth $42 per share. It was easy to see in its disclosures, for example, that the huge profits of its finance company were not true earnings, but the product of a lopsided tower of financial arbitrage wherein $600 billion of risky, illiquid assets were being propped up with massive debt and cheap hot-money funding.

  As it happened, GE’s sustainable earnings have been barely half of the hopped-up number it reported at the Greenspan bubble peak. During the two-year period through March 2011, for example, its EPS averaged only $1 per share, compared to the $2.20 per share in 2007.

  Based on the forward-year earnings that it actually delivered, therefore, its stock price at the 2007 bubble peak was being valued at 40X. Not coincidently, at the peak of the 2000 dot-com bubble it had also traded at 40X, a valuation multiple as loony then as it was in 2007.

  FINANCIAL ENGINEERING GONE WILD

  As the roller-coaster ride of GE suggests, the monetary central planners were determined to get the stock averages back to year-2000 levels and to resuscitate $5 trillion of household net worth which had been vaporized by the dot-com crash. Therefore, a stock market continuously juiced by 50 percent “takeover premiums” and nonstop share repurchase campaigns suited the Fed’s purpose.