C-Suite Racketeers——How Stock Buybacks Inflate The Market

John DVSo like a lot of people, I’ve gotten suckered into following the presidential race. As of last night, the Republican field has narrowed to just three candidates. That’s a long way from the 19 or so who started out, but who’s counting?

Not too long ago Carly Fiorina was still in the race. Everyone remembers Carly as the former CEO of Hewlett Packard who lost her job. I remember when Carly took over as the Chief Executive back in 1999. In her six-year tenure, the company bought about $14 billion of its stock, which was $2 billion more than it had made in profits.

Again, that was just in six years. Over the next six years, her first two successors bought back about $53 billion. That was as of 2011. I don’t even want to know how much the current CEO has purchased, as corporate buybacks have only grown more popular in recent years.

I was reading an article about buybacks published in Business Insider this past weekend. It said that they’ve accounted for almost all of the stock market’s gains since 2009.

That didn’t really surprise me. I knew the market’s rally over the past few years has been fueled by shenanigans. But, I was shocked by the sheer amount of buybacks that actually is.

The article quotes an HSBC research report that says S&P 500 companies have bought back $500 billion in stock in the last two years, and $2.1 trillion since 2010.

That’s an amazing statistic. And it gets weirder.

On a cumulative basis, individual investors and pension funds haven’t contributed one ounce to the market’s rise over that time. Every bit of it has come from these stock buybacks.

If you’ve also read that the Fed has been responsible for virtually all of the stock market’s moves since the financial crisis, it’s really the same point. Low interest rates made it cheap for companies to take on debt and then buy back their stocks.

It’s one way companies can juice their earnings per share because it reduces the share count. But, it’s a low-quality source of earnings growth. It has nothing to do with demand for a company’s product or services. And it comes at the expense of innovation and research and development.

It’s all financial engineering.

This chart shows that hundreds of millions of dollars have been added in buybacks each month and at a growing pace since 2010. It lines up with what we’ve seen in the S&P 500.

S&P 500 Buybacks Versus Stock Index

But, now that the bull market is long in the tooth at seven years old, this source of earnings growth may be coming to an end.

And because individual investors and pension funds have largely been absent in buying stocks over this period, there will be little to support the market’s prices.

What struck me as funny is that Liz Ann Sonders, Chief Strategist at Charles Schwab, thinks that individual investors will come into the market just as buybacks fizzle.

If there’s ever been an uber bullish firm on Wall Street, it’s Charles Schwab. It’s worth taking what their strategists say with a grain of salt.

It’s also a ridiculous assertion. Why would individual investors and pension funds all of a sudden come to the rescue when they’ve been on the sidelines the last seven years?

You mean the same individual investors who have seen their wages decimated and expenses skyrocket (health care and education to name a couple), are all of a sudden going to buy stocks hand over fist?

The same goes for pension funds. They don’t make huge market timing bets when it comes to allocating their assets. They’re even less likely to do so with valuations this rich, revenue growth so weak…

and with a stock market whose returns depend heavily on financial engineering!

Pension fund managers aren’t stupid.

And even if individual investors were dumb enough to plow into the market as the buybacks sputter out… that’s exactly what happens at the end of a bull market anyway. The big money runs for cover as the little guy who thinks he’s spotted a good deal gets squished.

So the logic that these guys will suddenly pile in is way off. Companies have cannibalized themselves with buybacks, and pretty soon they’ll all have to pay the price.

This is why we focus on financial engineering in my trading service Forensic Investor. Targeting these companies and then shorting them is going to pay off big.

One of my favorite short ideas in recent years was International Business Machines Corp. (NYSE: IBM)

Good ol’ Big Blue was aggressively buying back stock at inflated prices while its business imploded. We racked up a tidy profit in Boom & Bust on our IBM short, but that’s just a sample of what we’ve been able to achieve in Forensic Investor. Out of 13 closed positions, we had one loser. Clearly, I don’t like to close out a trade in the red!

More recently I recommended a short position on a large-cap industrial stock doing the exact same thing as IBM. I expect to continue to add to short ideas in the coming months as the financial engineering trend peters out, and the lack of earnings growth becomes exposed.

As far as I’m concerned, there’s no way earnings will meet expectations in 2016. And as those expectations lower accordingly, it’ll create great opportunity to profit.

John Del Vecchio
Editor, Forensic Investor