There is really only one thing that has been helping keep the U.S. stock markets buoyed during a period of poor earnings and souring economic sentiment: stock buybacks.
What Are Stock Buybacks?
Essentially, a stock buyback is when a publicly-listed company purchases its own shares on the open market, thereby reducing the number of outstanding shares (and typically raising its own stock price). This is alternately known as a share repurchase or repurchase agreement.
The primary reason that a firm might buyback its own company shares is because it feels its stock price is undervalued. By taking more shares off the market, stock repurchases invariably boost the share price. Because the available supply of shares is reduced, “it increases earnings per share [EPS] and tends to elevate the market value of the remaining shares,” according to Investopedia. This makes perfect sense.
Wave of Buybacks
But are stock buybacks always a good thing? That depends. One clear signal that a buyback sends is that the company feels it has no better alternative use for those funds—such as research and development (R&D), investing in capital expenditures, or sinking that extra money into better compensating its employees (or finding higher value employees). As just about any finance wonk will tell you, there’s virtually no corporation in the world that couldn’t benefit from spending cash in one of these areas.
This is why the explosion of stock buybacks over the past decade is a bit of a concern, and is revealing of the inflated values on Wall St. Buybacks hit their peak in 2007, right before the financial crisis (conspicuously enough), and took a breather before resuming at an increasingly fast clip over the last few years.
In fact, data compiled by Bloomberg shows that share repurchases are one of the main drivers that drove U.S. equities indices to their highs in 2015 and have subsequently kept those stock markets afloat during the sharp correction we’ve been seeing of late. The S&P 500, for example, has seen profits for its listed companies decline for three consecutive quarters while buybacks have surged. In many cases, this is even being done on margin (i.e. with credit). There is no way is is sustainable for companies to borrow money simply to use it to repurchase their own shares. By some estimates, this is the lone reason that Wall St has been able to maintain its current bull market by the skin of its teeth.
At the current pace, the year-end total of stock buybacks in 2016 may reach $590 billion, just topping the annual record set in 2015. The problems have not escaped some of the biggest players in finance: David Kostin, the chief U.S. equity strategist at Goldman Sachs, was recently quoted, “Corporate buybacks are the sole demand for corporate equities in this market.” This should be taken as a worrisome sign for anyone who still believes the stock market isn’t one big casino. If the only people interested in buying shares are the companies that issue them, we are kidding ourselves.
The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.