FINANCIAL ENGINEERING CONSENSUS (Positive Consensus/Bear Market Indicator): Stock buybacks at 20 year highs

March 7, 2015

Stock prices go up when a company can demonstrate that it is capable of generating profits in the past and more importantly in the future. In the last 6 years, stock prices have gone from the bottom left of the chart to the top right of the chart without much resistance. This should imply that business must be brisk for most companies and that should be reflected in their stock prices. When you dive in to the performance we find that their performance has been driven more by financial engineering than organic growth. It is not a coincidence that company profits have been going up at the same time as companies have been engaging in an aggressive program to buy back their own stock and increase dividends. The latest data shows that in US the rate of share buybacks is at a 20 year high.

“Stock buybacks, which along with dividends eat up sums of money equal to almost all the Standard & Poor’s 500 index’s earnings, vaulted to a record in February, with chief executive officers announcing $104.3-billion (U.S.) in planned repurchases. That’s the most since TrimTabs Investment Research began tracking the data in 1995 and almost twice the $55-billion bought a year earlier….

…Even with 10-year Treasury yields holding below 2.1 per cent, economic growth trailing forecasts and earnings estimates deteriorating, the stock market snapped back last month as companies announced an average of more than $5-billion in buybacks each day. That’s enough to cover about 2 per cent of the value of shares traded on U.S. exchanges, data compiled by Bloomberg show.”

We can thank the Federal Reserve or as I call them Club Fed and their 6 year shock and awe program of printing money to keep interest rates low. This has provided incentive for companies to borrow money at next to nothing and use the proceeds to buy back stock and issue dividends. Increasing their debt levels lowers the firm's cost of capital and subsequently increases the valuation of the company. As stock is taken out of circulation, profits per share go up and the market is happy to reward. Usually when interest rates are low, companies will borrow capital to reinvest in their business by increasing research and development, hiring more people or investing in more productive capital equipment. This hasn’t happened. Management has determined it is easy to jack up profits by tinkering with their capital structure rather than making hard investment decisions about the products and services they offer.

There’s nothing wrong with buying back stock if you think your company’s stock is undervalued. The reality is many companies have been buying stock at inflated prices which is not a great use of their scarce capital.

As long as Club Fed and DJ Janet Yellen continue to keep the party going, the environment is there for companies to continue to engage in the same behaviour. It’s an unsustainable program and at some point Club Fed is going to have to start increasing interest rates which would reduce the incentive to keep buying back stock.  All of a sudden stock prices will have to reflect the fundamentals of the business which over the past few years has been mediocre at best. Something will have to give at that point when investors have their A-Ha moment.