Why Buybacks Are Terrible For Our Stock Market

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Seven years into the bull market and there is only one main buyer thatai??i??s still driving up stock prices. Ai??We know individual investors still bare the scars of the financial crisis, and that despite witnessing the major indices more than double from their 2009 lows, they have been reluctant to invest.Ai?? This has led to calling this ai???the most hated bull market ever.ai???bullish

And maybe that moniker is well deserved once we drill down and look at what has been driving this bull market. Investors have clearly not been in a buying frenzy…even as we move towards all-time highs. Nor was the January sell off, which offered the 10%-15% correction that had been so elusive for the past years, viewed as a chance to ai???buy-the-dip.ai??? In fact, money flows from equity funds have been negative over the past few weeks, even as stocks rallied.Ai?? So whose been buying stocks?

The corporations themselves in the form of buybacks.Ai?? And that has been the case through most of this 7-year bull market. The graph below shows that households and retirement funds have been net sellers of stocks, even when the flow into ETFs is accounted for, over past 7 years.

Buybacks 7 year 3.15.16

And while buybacks were basically shelved for the first 5 weeks of this year during earnings season, they are back in force, with some $110 billion in repurchases over past three months. Ai??If interest rates remain low, we can expect 2016 to be a record $650 billion in buybacks. Which is both a good and thing.

The Incredible Shrinking Stock Market

When a company buys back stock, it is often positioned as ai???returning cash to shareholdersai???…but it really isnai??i??t. At least, notAi??in the same way a dividend does. Buybacks are used help boost earnings per share (EPS)Ai??results. Since the profits are spread out over a lower denominator (shares), they make the EPS look a lot bigger. Repurchased shares get retired, basically locked in the corporate vault, and are not included in calculating EPS. As such, buybacks represent a tailwind to share prices. Ai??It is estimated that over the past five years, the number of total shares outstanding of S&P 500 companies has declined by 31%.Ai?? Basically, the stock market has been shrinking.

This may seem like nothing more than some unproductive, sleight-of-hand accounting where no one gets hurt; but buybacks actually do have a significant downside. The repurchased stock is dead, and the cash is in the hands of the seller. Where once there was a liquid stock and cash, now it’s just cash . So half the previously existing economic value has been eliminated, and the outstanding share count has gone down. Which is fine–until you remember EPS isnai??i??t a measure of financial health net income is.

What the company retainsAi??is debt load and interest payments. Companies very, very seldom flip from buying back stock to doing secondaryai??i??s. Doing so would absolutely kill their shares. That means liquidity is restricted even beyond interest.Ai?? Financial commentator Jeff Macke describes buybacks thusly, ai???A buyback is financially tantamount to buying shares and lighting them on fire, then paying an annual fine for pollution. If youai??i??re lucky, the interest rate paid on buyback loans is roughly equal to the dividend payments saved.ai???

It also means companies are not investing in research, capital equipment or other items on which to build future growth.Ai?? Goldman SachsAi??estimated that 27% of the cash that companies spend in 2016 will be used for stock buybacks. That percentage is equal to what companies spent in 2015, and higher than the 25% in 2014. In total, SPY components will spend $608 billion this year on stock buybacks, even more than theAi??$568 billionAi??spent in last yearai??i??s zero rate environment.

Buybacks plus dividends 3.15.16

William Lazonick, Ai??Professor of Economics at the University of Massachusetts warns such unproductive use of capital bodes ill for the U.S. economy, stating, ai???in each year since 2010, corporate demand via buybacks and M&A has represented the largest source of inflow to the U.S. equity market. Ai??Ai??He estimated that the 449 firms in the S&P 500 that were publicly listed from 2003 through 2012, used 54% of their earningsai??i??a total of $2.4 trillionai??i??to buy back their own stock. Dividends absorbed an extra 37% of their earnings. That left little to fund productive capabilities or better incomes for workers.

If You Canai??i??t Beatai??i??em, Buyai??i??em

Since buybacks seem to be fact of life we might as well try to benefit from it.Ai??Ai?? Here are three of some of best blue chip that will also be big buyers of their own shares:

Apple Stock CrashesApple (AAPL) with its huge cash hoard is expected to remain the single biggest buyer in terms of shear dollar amount.Ai?? It contributed $35 billion of the roughly $580 billion in 2015 S&P 500 buybacks and is expected to buy another $30 billion in 2016. Thatai??i??s about 5.5% of its current market capitalization.

Gilead Sciences (GILD) the big pharmaceutical company is expected to repurchase $12 billion of its own stock. Ai??The trades at a relatively low p/e of just 7x forward earnings, despite expectations for low, double digit growth because of concerns over the future drug pricing.

Coming a bit under the radar is NikeAi??(NKE), which just launched a $12 billion buyback program to commence once the current $8 billion program ends. NKE is quite lower since announcing the plan back in December. However, $12 billion is good for more than 11% of all NKE shares outstanding.

But before becoming too enamored with buybacks, one should consider how shares of IBM have fared. The company has been the poster child of buybacks and dividends, using nearly 75% of its free cash, and shrinking its share base by 68% in just the past three years.Ai?? The stock is down some 30% during that time period.

Kind Regards,

Steve Smith

Steve Smith is an expert options trader with 25 years experience in the markets. Steve was a seat-holder of the Chicago Board of Trade (CBOT) and the Chicago Board Option Exchange (CBOE) from 1989 ai??i?? 1997. Steve is currently the editor of The Option Specialist and runs the 20K Portfolio Program which provides all types of options trades for all types of traders.

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