This Invisible Hand Giving a Boost to the Stock Market
The “invisible hand of the market” is keeping the stock market high, and there isn’t much talk about it. Were it not for this, indices would be much lower.
To be more specific, I’m talking about share buybacks. Companies have become major buyers of their own stocks as of late.
Advertisement
In the first quarter of 2019, S&P 500 companies purchased $205.8 billion worth of their own shares and spent $823.2 billion on buybacks, marking year-over-year increases of 8.9% and 43%, respectively. And over the same period, 25% of S&P 500 companies have reduced their share count by at least four percent. (Source: “S&P 500 buybacks decline in Q1 2019 after four consecutive record quarters; still post 2nd highest quarter ever,” Cision, June 24, 2019.)
Looking further back, between the first quarter of 2015 and the first quarter of 2019, S&P 500 companies have purchased $2.64 trillion of their own shares. That’s about equal to the gross domestic product of United Kingdom.
But don’t think for a second that the buying is over; companies still have massive share buyback programs in place.
Buybacks Are Financial Engineering
Now, you might hear otherwise—that stock buybacks are great. And at times, they are; after all, they increase shareholders’ equity. However, buybacks are also a kind of financial engineering.
When companies buy back shares, they are essentially doing two things.
First, they are essentially reducing the number of outstanding shares, which can increase earnings per share without any change in net income. This makes their earnings look better than they are. And if you follow the market closely, you know that investors pay a lot more attention to earnings per share than anything else
Second, share buybacks create demand for stocks. When it comes to trading, traders usually try to look for companies where there are a lot of buyers, as more buyers could mean higher prices.
As companies buy back their shares, it starts to look like someone big is buying in. This could lead traders to jump in and buy, even when the company’s fundamentals are lacking.
Stock Market Crash Ahead?
The stock market has gotten a big boost from share buybacks over the past few years. My concern, however, is what will happen if companies suddenly decide to pull back on their buyback spending.
We are seeing economic data taking a turn for the worse, meaning a recession could be brewing. In times of recession, will companies spend money to buy back their own stocks, or will they use their cash elsewhere?
Here’s what I think: if companies pull back on their buybacks, we could see a stock market crash.
