Market Metrics That Could Spell Trouble for Investors

September 29, 2014 • Education • Tags: , , ,

Most companies (big and small) have taken some measure of financial engineering to boost bottom line. With the DOW (DIA) and S&P 500 (SPY) floating around all time highs and the NASDAQ (QQQ) trending towards 2000 peak levels, the share repurchases seemed to have worked for every party involved. Investors are enjoying capital gains, management rewarded with bonuses and Wall St is seeing record profits. What happens when we surpass moderate share-repurchase levels and become over dependant on financial engineering? Past occurrences suggest a downturn in markets.

Share Repurchase Nearly at 2007 Levels

Thanks to the Fed’s easy monetary policies, corporations have leveraged balance sheets by taking on debt and using the capital to repurchase shares. Financially, this makes sense especially if earnings yield is greater than bond yields. However, the large volume of buybacks has inflated earnings when fundamentals, such as revenue growth, are not as rosy.

During the first quarter of 2014, share buybacks nearly matched the previous record high during Q3 2007 (below). As we saw in the housing bubble, corporations buy most aggressively in later stages of bull markets and stop repurchases when prices plunge to “cheap” levels. In other words, one can classify corporations as the worse buyers of their own stock.

quarterly share repurchase


Latest Numbers Show Concerning Decline in Buybacks

FactSet reported that Q2 2014 buybacks declined YoY (-1.1%) for the first time since Q3 2012 and buybacks showed the most severe QoQ decline (-22.9%) since Q4 2011. The biggest contributors to the drop in share repurchases were the largest companies buying back stock earlier during the year. Apple (AAPL) and IBM (IBM), combined, repurchased $18.7B less in Q2 than Q1.

Other big buyback spenders (FedEx, Boeing, Abbott Laboratories to name a few) combined to spend $6.2 billion less in Q2 than Q1. This is a concerning trend as it could signify these companies may believe their respective stocks are overvalued.

In the last decade, a steep drop in shares repurchased came during the unfolding of the “Great Recession” in 2H of 2007 and the 2011 summer “correction”. If Q3 share buyback numbers come out with a similar outlook to Q2, investors should be concerned as yet another indicator is signaling downward market pressure.

Bull Market Out of the Ordinary with Drying Volume

The chart below shows the performance of the S&P as the bold line and the volume traded as the bars. As the S&P rose from the lows of 2008, volume has been on a steady decline.

declining sp500 volume

A factor playing into declining volume is the amount of share buybacks that have been authorized by corporations. Repurchased shares have lowered the aggregate number of common shares outstanding (seen on graph below). Therefore, due to the limited number of shares available, investors have bid market prices higher. Simple economics tells us that price rises as supply is restricted. However, a healthy bull market should rise on expanding volume, indicating rising demand, not drying volume.

aggregate common shares outstanding

What the Future Could Hold

The drop in Q2 share repurchase figures discussed above could be the start of a trend in which corporations become more conservative with share buybacks. This would result in further volume declines and a cooling of valuations due to less demand.

A rise in rates would also reduce capital borrowing for the use of share repurchase. Companies would need to either repurchase shares using generated cash or lower buyback levels. Both scenarios result in lower shares repurchased and thus a potential decline in market prices.

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