As I pen this blog, the S&P 500 had broken out to all-time highs and sustained that important technical event for several weeks. When investors begin to “peek under the hood” as to the reasons why the markets are at all time highs, question arise. The prices paid for shares of companies are a reflection of investors’ expectations as to future growth and earnings potential. As we are currently in the midst of an earnings deluge, one can’t help but notice that revenues/sales – called the “top line number” referencing its position on a profit and loss statement – are still not growing the way investors typically like to see. Yet at the same time, equities are moving higher. What gives? Companies are exceeding estimates on the earnings-per-share number (EPS for short) or what we call the “bottom line”. How is this happening? One simple word – buybacks.
Institutional and individual investors are not the only players in the equity markets. Corporations also buy shares of their own equities as a means of supporting the value of those shares to benefit their shareholders. How does that work? The EPS number is calculated by taking the earnings figure and dividing it by the number of outstanding shares – also called the float. One way to make that EPS number higher is to reduce the float by purchasing shares in the open market causing other investors to compete for fewer remaining shares. How influential is this impact? Let’s look!
Corporate America is sitting on a great deal of cash needing to be utilized. Many companies have been on a sort of buying spree for their shares as they argue that buybacks are a better use of investors’ capital than potential money-losing projects, particularly in an uncertain economic climate. In the 12 months ending in March 2016, operating earnings – a company’s revenue less expenses – across the S&P 500 companies has dropped to $854.9 billion from $989 billion a year ago. So why are equities at all-time highs when there may be a large question mark as to true growth? The buyback! In this same period, buybacks increased to $589 billion from $538.1 billion. This makes corporations their own most reliable investors. By channeling funds into their own shares, companies are making up for the gap in demand from individual investors, mutual and pension funds and foreign investors. According to the Federal Reserve, net outflows from the American stock market in the first quarter of the year were more than compensated for in buybacks from corporations – the net effect was an inflow of cash. A recent report issued by Goldman Sachs noted that buybacks will likely remain the largest source of U.S. equity demand this year.
So what makes this an issue? History! Surges in buybacks haven’t always proven to provide long lasting bullish behavior. When was the last time companies set a 12 month buyback record? December 2007 – right before the stock market topped and became aggressively bearish in 2008. Given incredibly low-interest rates for the foreseeable future, coupled with so much cash on hand for companies, this current trend can easily continue for some time. At some point, however, this “elixir” for share prices will no longer be as effective and will only be yet another symptom of an overextended equity market. The good news in all of this? At OptionsAnimal, we know how to trade ALL market environments for profitability so that should a “day of reckoning” be in the cards, we can protect our investments and profit during the wake-up call!