Rathbun: A silent driver of the marketWritten by Gary Rathbun | | GaryRathbun@PrivateWealthConsultants.com
For every complex problem, there is an answer that is clear, simple and wrong. –H. L. Mencken
In looking at the stock market and explaining why it is reaching new highs and continues to be supported, many people, myself included, always mention that the actions of the Federal Reserve are driving the market. While I believe this to be true, there are some aspects to these actions that need to be considered.
The Fed’s zero interest rate policy supports the market in a couple of different ways. First, the quantitative easing, or printing money out of thin air, has intentionally pumped up the market. Secondly, central banks are directly buying stocks since “being too big to fail” has the advantage of having a taxpayer safety net. Finally, and this is the stealthy one, companies are incentivized to buy back their own stock, thereby driving the entire market up.
In the past, it was usually a good thing if a company purchased its own stock back and retired it as treasury stock. This action decreases the amount of outstanding shares and essentially increases the value proportionally for the remaining shares. The earnings of the company are then spread over fewer shares and potentially increase the dividends to the shareholders. There even have been investment strategies where people look for companies that buy back their own stock.
On the negative side, when a company buys back its own stock, it is saying that there is nothing better to invest its money in at the present time. This includes research and development, acquisitions, capital improvements and simply building its business. To me, this is where we are going to pay a price in the near future. Companies are focusing on the bottom line and not spending much time or resources on the top line.
Focusing on the bottom line will cause a company to cut costs where it can and one of the most expensive items for a business is labor. This is part of the reason that unemployment is staying high and new jobs are not being created. Profits are up and companies are cutting costs to the point of unsustainability of their products and services.
Since the beginning of the year, big U.S. companies have been given permission to buy back $286 billion of their own stock, according to Birinyi Associates, a market research firm. You can start to see some of the effect this will have on the overall market. A quarter of $1 trillion into the market creates a huge amount of liquidity that supports the overall pricing of the market. The effect on the stock price of the company buying back its stock is almost immediate and generally significant compared to the amount of the purchase.
In the last five years, the total amount of buybacks has dumped over $1 trillion into the market. Couple this with the central banks purchases and it’s not hard to see where the support is coming from. During this same time, large pension funds, investment brokerages and local and state governments have been net-sellers.
Forty percent of the increase in the earnings per share of the S&P 500 companies in the last 12 months came from reducing the number of shares through buybacks. If the buybacks would not have happened, we would probably have a completely different number for the Dow and the S&P 500 than we have today.
Eventually, this liquidity will dry up and we will have a situation where we have more sellers than buyers and the market will become more volatile with much lower volume. Reported earnings will also become more realistic and thus alter the valuations of some of the companies in the index.
Buybacks are the silent support but they can’t be supportive forever.
Gary L. Rathbun is the president and CEO of Private Wealth Consultants, LTD. He can be heard every day on 1370 WSPD at 4:06 on After the Bell, every day on the Afternoon Drive, and every Tuesday, Wednesday and Thursday evening at 6 p.m. and Monday through Friday at 10 p.m. throughout Northern Ohio on Eye on Your Money. He can be reached at (419) 842-0334 or email him at firstname.lastname@example.org.
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