Stock buybacks can be great for shareholders: They increase earnings-per-share and reduce the number of shares being traded, pushing prices higher. But sometimes they can signal a weak equities market and a weak economy, one where managers are doing everything they can to mask poor results and have the cheap money to do it.
And it could all come crashing down. Let me explain.
Currently, buybacks are at the same level reached before the last stock market top. I expect buybacks will end sooner rather than later, but they will continue as long as executives have capital to spend and weak earnings to mask.
Take a look at the chart below, which clearly shows how aggressively publicly-traded company executives are buying back shares. Why? To keep the earnings-per-share number high and cover up lack of sales and growth. Eventually, this will come to an end.
What we're seeing here is a combination of "earnings management" and cheap money due to loose monetary policy.
"Earnings Management" is the practice of attempting to intentionally bias financial statements in order for them to appear better looking than they actually are. There are red flags for two different forms of revenue manipulation. One is manipulating earnings through aggressive revenue recognition practices, which is the most common reason that companies get in trouble with government regulators for their accounting. The other red flag for manipulating earnings is through aggressive expense recognition practices, which is the second most common reason that companies get in trouble for their accounting practices.
Share buybacks allow companies to repurchase their own shares on the market. Why do those companies want to do this? The number of shares held by the public will be reduced, which will increase the earnings per share, even if the total earnings are the same. The value of shares being traded will increase. It is valuable for a firm's manager to buy back shares when it believes that the firm's stock is currently trading below its intrinsic value. Executive compensation is often tied to executives' ability to meet earnings-per-share targets. When it is difficult to meet the targets, the executives may repurchase shares in order to receive their executive or managerial bonuses.
Buybacks are not all created equal. The skills of the management in capital allocation and the culture of the company can make a difference in the outcome of the buybacks. Although buybacks are viewed as positive for stock prices, a lot of them happen at exactly the wrong time and destroy value for shareholders. (More on this from my interview with HoweStreet radio about how these high stock prices are deceiving.)
But before any of that can happen, company managers need a place to get the money to buy back shares. If earnings are relatively weak, how do they get the money for such lavish spending? Central banks with low interest rates and quantitative easing policies.
Global central bankers continue to try spend their ways out of their contracting economies. They have expanded their balance sheets buy buying bonds as a way of providing liquidity to the private sector. These policies have sent interest rates into unprecedented historical lows. European countries and Japan have sent their rates into negative territory. Low interest rates have encouraged corporations to borrow more money.
Implementation of these monetary policies temporarily assisted the economy so as to reduce the impact of a new economic and financial crisis back in 2008. However, it was not the prudent policy to continue after everything became stabilized. The real solution was for an implementation of a new round of fiscal policies. This would have restructured the debt and allowed the global financial system to reset itself. Unfortunately, because that didn't happen, we are currently sitting on a ticking time bomb in all global financial markets.
True GDP growth comes from increasing productivity and real employment and allocating resources for proper economic activity. And with all the cheap money going to share buybacks rather than capital spending, true growth is not what we're seeing.
Why is it that banks are holding so many excess reserves? What does the data tell us about current economic conditions and about bank lending behavior and practices? Some observers claim that the large increase in excess reserves implies that many of the policies introduced by the Federal Reserve in response to the financial crisis have been ineffective. Rather than promoting the flow of credit to firms and households, the data, as shown in the chart below, indicates that the money lent to banks and other intermediaries by the Federal Reserve since September of 2008 is simply sitting idle in banks' reserve accounts.
Global governments have built up large debts that far exceed their GDP. They have even larger future liabilities in terms of pension and health care for retired workers. So how is it that investors can anticipate an increase in profits, which is necessary to generate and maintain higher stock prices?
Because of these conditions, expectations of future corporate profitability will fall and that equities will experience a substantial decline very shortly. This also means that unless the conditions, as cited above, change, equity prices could be the same as they were in the early 1980s or lower.
As Bill Gross, noted bond investor at Janus Capital Group Inc., said, "investors should worry, for now, about the return of one's money, not the return on it. Our credit-based financial system is sputtering, and risk assets are reflecting that reality even if most players (including central banks) have little clue as to how the game is played."
I have been warning about the U.S. stock market topping out for about a year now. This lengthy process is taking a long time to play out, as most major market tops do, but each month we move closer to another life-changing financial event for the global economy.
While I am not yet short the U.S. stock market so that I can profit from falling prices, I have been long bonds and precious metals for a while and enjoying the ride up.
Various markets are starting to become very interesting, and huge opportunities are just around the corner.
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This article is commentary by an independent contributor.
Chris Vermeulen is full-time trader and research analyst for TheGoldAndOilGuy Newsletter.