After a weak beginning to the year, the Dow has shot up 1,275 points of 7.7% during March. Stocks are positive for 2016 and are trading above moving averages and key levels of support. All these are great signs of celebration, right?
Well maybe. A challenge is there is not a booming economy to support the market rise. There is also quite a bit of uncertainty for the future with the election year, weakening world economy, threat of terrorism, and a $19 trillion debt at home. It would seem in these times, we would not see a strong bull market.
Part of the reason for the market’s rise over the past decade is the huge amount of corporate stock buy backs. Deutsche Bank reports that the total flows of money into the market has remained stable during a time that $2.7 trillion of shares of S&P 500 stocks have been retired. The drop in the supply of stock and constant money in the market will cause prices to increase. This capital could also be used for future R&D, capital improvements, or business expansion, but it is not.
Since 2011, the number of companies in the S&P 500 that have purchased back shares totals between 360 and 390 each quarter. In 2015 alone, the total of these buy-backs exceeded $568 billion, according to Factset.com. The growth in the buy-back craze coincides with a steep rise in the market since 2009. It is not the only reason for the market rise, but it is one strong influencer of prices.
Since the fourth quarter of 2014, there has been a drop in corporate profits, while there is an uptrend in the percentage of corporate profits that are used for stock repurchases. In the last quarter 2015, 75% of the profits of the S&P were used by companies to purchase their own stock. Profits don’t seem to matter to the 140 companies of the S&P 500 who bought back more stock than their trailing twelve month (TTM) net income. Also close to 150 of the 500 spent more on buying back stock than they had in TTM free cash flow.
The drop in outstanding shares via the buy backs creates the temporary illusion that earnings per share are increasing. In many cases this is not only because of increased profits but is also from a decrease in shares outstanding. Increasing EPS is what investors want to see. It also benefits corporate executives who can cash out on their fat option bonuses.
Another issue that goes even farther, is the earnings manipulation put forth from companies. Companies have to report their earnings using GAAP. But many also report non-GAAP earnings. Non-GAAP accounting lets companies exclude certain losses from their accounting since they are supposed to be one-time charges by nature. There is a problem though when one time charges continue to occur quarter after quarter.
The S&P 500 non-GAAP earnings for 2015 was $118/share. GAAP earnings ended at just $87/share, 26% lower than the non-GAAP earnings. GAAP earnings in 2015 were only $5 higher than what they were in 2006 before the meltdown.
So much for a healthy “recovery”.
A group of analysts, like Societe Generale’s Andrew Lapthorne, Deutche Bank’s David Bianco, Capital Wave’s Shah Gilani, and Berkshire Hathaway’s own Warren Buffet, have all expressed concern about how the distorted view of earnings is impacting investors.
It will be interesting to watch the earnings that are reported from companies with exposure to falling commodity prices and the banks that have financed them. Will they resort to a lot of non-GAAP shennangians? Will other companies continue to use excess cash to buy back shares instead of investing in their future growth?
Be aware that the market can be manipulated, both with decreasing outstanding shares and also by manipulating earnings. In such times like these, extra caution is warranted by the prudent investor.