THE BASICS OF INVESTING WITH RYAN JAMES: STOCK BUYBACKS AND FUTURES CONTRACTS

By Ryan James

Stock Buybacks

Public companies have different options for rewarding their investors during periods of noteworthy performance. Many deliver returns in the form of dividends. But a company can also perform a stock buyback, repurchasing a set number of its outlying shares, showing investors that the company has confidence in its future performance, increasing the volume, and boosting the stock price.

While this does help shareholders, it diverts companies’ funds away from helping people in more dire need, bringing about social dilemmas and the controversy that follows. Historically, this money, which has often come from government-issued corporate tax breaks, such as under the Trump administration (2016-2020), has been used for stock buybacks rather than reinvesting in the companies’ employees and social causes or growth, innovation, and production.

Goldman Sachs predicts that stock buybacks by S&P 500 companies will exceed one trillion dollars in 2022. Buybacks reached an all-time high of $882 billion in 2021.

Despite the social ramifications, stock buybacks are a great, legitimate way for companies to reward their shareholders during times of excess funds.

The Biden administration and the SEC are pushing back against companies performing stock buybacks because of social qualms. Many believe that this money could be better spent on employees, social aspects of the companies, research and development, and the products or services produced by the companies. President Biden’s fiscal year 2023 federal budget plan seeks to target corporate stock buybacks, potentially stimulating companies to transition to higher dividends rather than steady share buyback programs. This legislation “would align executives’ interests with the long-term interests of shareholders, workers, and the economy by requiring executives to hold on to company shares that they receive for several years after receiving them, and prohibiting them from selling shares in the years after a stock buyback,” according to the document.

Buybacks provide advantages for the issuing companies aside from raising the stock price (and market capitalization thusly), amplifying shareholder confidence and demand, and strengthening the companies’ control and autonomy. They also provide a safer, lower-risk alternative to increasing dividends; nonetheless, dividends provide a satisfactory method for long-term investors to realize their gains without selling stock. Investors treat buyback programs as bonuses, giving the companies more flexibility. Canceled or subdued dividends often result in backlash from the shareholders unlike those of buyback programs. The opposite also holds; the implementation or expansion of stock buyback programs typically excites shareholders more than those of dividends.

“Do not allow setbacks to set you back.” ― Stacey Abrams, Georgia politician, lawyer, voting rights activist, and New York Times bestselling author

Futures Contracts

The Corporate Finance Institute defines a futures contract as, “An agreement to buy or sell an underlying asset at a later date for a predetermined price.” The futures market is usually used to make less traditional trades and to track how securities are performing during the pre-market and after-hours; it is also utilized for the trading and monitoring of commodities.

Futures contracts are also called derivatives. They are often used to track commodities such as oil. The crude oil market, especially in the United States, is tracked by two main indexes, West Texas Intermediary (WTI) crude futures ($OIL) and Brent crude futures ($BRENT). The former focuses on American oil while the latter focuses globally.

The owner of a futures contract typically owns a representation of a commodity but may have to take ownership of the physical good in some cases. These contracts are called “futures” because they denote a transaction that is to be held in the future. They have expiration dates, at which time the transaction must occur. Buying a derivative is essentially going long on the security—betting that the price will go up in the future. The most notable futures are index futures, those that track the major indexes, the Dow, the S&P 500, and the NASDAQ.

News Affecting The Market

Inflation is the devaluation of a currency—the purchasing power of the currency decreases, thus driving up prices. The United States dollar ($USD) has experienced significant inflation recently; the March 2022 consumer price index (CPI) showed an annualized inflation rate of 8.5%, the highest level since 1981, though many believe that this may truthfully be quite higher.

The CPI measures the change in prices paid by consumers for a “basket” of goods. The main cause of inflation is an increased quantity of dollars in circulation because the Bureau of Engraving and Printing, under the Department of the Treasury, has been printing much more money. This devaluates the currency because there is more of it in circulation.

The Federal Reserve has had interest rates at historically low levels because of the COVID-19 pandemic and has been slow to raise them. This did help avoid further economic distress during the 2020 recession, but this expansionary monetary policy was exercised for too long, leading to further inflation; money could easily be borrowed with little risk during periods with low interest rates, and consumers rush to buy when interest rates start to rise.

The Department of the Treasury printed $4 trillion in 2020 and the Fed’s balance sheet reached a peak of $7.7 trillion as it expanded government bond purchases to increase employment and decrease interest rates. A balance sheet is a financial report that represents the equity held by an entity.

Inflation is additionally driven by exceptionally high consumer demand and little supply to sustain it, bringing about fears of hyperinflation or stagflation. Hyperinflation is the rapid and uncontrolled devaluation of a currency, and stagflation is a state of economic stagnancy—both unemployment and inflation are high, and economic growth is slow or negative.

The supply chain is the multi-stage system through which all goods go from manufacturer to retailer or consumer. COVID-related restrictions and worker deficiencies have caused massive disruptions in the supply chain. This causes retailers to have shortages of many items, but consumer demand for these items is highly potent nevertheless.

Worker shortages force employers to pay higher wages, and they offset these costs by increasing the prices of their goods and services. This could potentially, though unlikely, create a wage-price spiral, the scenario of employers raising prices to offset higher costs (including wage increases and price increases); this requires the companies to pay their workers more because of a higher cost of living, increasing prices to compensate for this, ultimately creating a devastating spiral that drives hyperinflation or stagflation. The sole resolution for this is to increase prices to the point that consumers can no longer afford goods, drastically reducing demand and likely inducing an economically disastrous recession. Many economists refer to this using the phrase, “the only solution for higher prices is higher prices.”

In regards to fiscal policy for fighting inflation, the government is enacting acts and executive orders to increase production and competition in an attempt to lower prices and increase output for American-made goods. The Federal Reserve’s current monetary policy is to slowly raise interest rates. The 30-Year Treasury yield has surpassed 3%, its highest rate since 2019. The average interest rate on a 30-year mortgage for a home has reached 5.11%, its highest level since 2010. Home prices continue to soar as the prices of commodities used to build the houses (lumber, et al), mortgage rates, and demand escalate. Supply is dwindling in addition to these factors. Home prices hit an all-time high of $375,300 in 2022, up about 15% from last year. Higher home prices and mortgage rates have consumers paying about 38% more than they were at this time last year.

Increasing commodity prices are causing the proliferation of the prices in the goods made with them. The price of lithium, a major component of electric vehicle batteries, is up approximately 480% year-to-date. Lithium makes up about 30% of the cost of building an EV. Elon Musk, the CEO of Tesla, claims that the company may begin mining lithium because of the astronomical prices. A major component of the Biden administration’s agenda is to ramp up domestic electric vehicle production and use, so President Biden introduced the Defense Production Act, aiming to invest $750 in mining operations for lithium and other raw materials used in the creation of electric vehicle batteries. Rivian’s CEO RJ Scaringe acknowledged, “90% to 95% of the supply chain does not exist.”

The war in Ukraine is an additional driving factor of inflation in the United States. Russia and Ukraine are major exporters of some goods, but sanctions on Russia and military aggression against Ukraine restrict these exports. Countries are refusing to purchase many Russian goods, and it is difficult for Ukrainians to produce goods and export them out of the country. Some of these goods include corn and wheat; corn has been especially impacted, seeing prices reach a nine-year high.

Oil futures are at historically high levels. This comes as Russian oil becomes untouchable to much of the world. Natural gas is up about 113%, the highest level since the Global Financial Crisis of 2008. Climate change is causing especially strong and frequent winter storms, inducing the need for heating which often uses natural gas. Nearly all goods are made from oil and/or use it in some capacity, contributing to rising prices. Items from clothing to plastics are made from petroleum, and goods must be transported; gas is used in the trucks that carry them, so shipping expenses are high. Gasoline prices have recently hit an all-time high because of the record oil prices. Gas prices typically lag behind oil prices by about 3-4 days, but the two are intrinsically linked. The average national gas price in the US surpassed $4.

Bottom Line

Thank you to the readers who have read all ten issues thus far. This issue covers share buybacks, their benefits and drawbacks, the governmental scrutiny over them, and the potential future without them; the functions of futures contracts; and the root causes and significance of recent higher oil and gas prices.

Disclosure: All statements and opinions expressed in this article are objective and my own. I am not a financial advisor. I do not recommend the trade or use of any particular stocks or services. I acknowledge the risks of investing.