Are Buybacks a Warning Sign?

11/11/2013 9:00 am EST

Focus: STRATEGIES

Joon Choi

Senior Portfolio Manager, Research Analyst, Signalert Asset Management LLC

At the end of the second quarter of this year, S&P 500 companies (not including financial stocks), had over $1.2 trillion in cash and short-term investments on their balance sheet. This cash position is at its historically high levels, observes Joon Choi in Systems & Forecasts.

So, what are corporations doing with this excess cash position? They are buying back their own stocks! And aggressive stock buybacks are pushing stock prices higher.

I have listed primary reasons for the current trend of buying back stocks:

1. The companies see their stocks as undervalued that would make good investments.

2. Buying back stocks enables companies to raise the earnings per share without actually increasing earnings.

3. Many company executives have stock option incentives tied to their performance, so they initiate or increase stock buybacks, which creates extra demand for the underlying stock, resulting in price appreciation.

4. Stock shareholders influence company executives to either buy back shares or declare dividends. This action usually leads to an increase in the underlying stock price.

5. Alternate uses of cash, such as investing in new projects and acquiring other companies, may not be as attractive and therefore, companies invest in their own stocks.

How much have S&P 500 companies bought back since 2009? The answer is approximately $1.4 trillion. To put this number into perspective, S&P 500 companies' current total market cap is about $15 trillion, and $6 trillion at the bear market low on March 6, 2009.

It's difficult to determine how much share buybacks contributed to the stock price appreciation since 2009, but it's safe to say share buybacks made a significant contribution to our current bull market.

Meanwhile, investors have been flocking to buy PowerShares Buyback Achievers (PKW), pushing the price into overbought territory.

Currently, the monthly relative strength indicator (RSI) reading is 83.7. (A reading over 70 is considered to be overbought.) To put this figure in perspective, the monthly RSI of the Nasdaq Composite was 85.9 on March of 2000 (the index peak), and we know what happened afterwards.

Bubbles are formed when investors crowd into investment vehicles; it's difficult to exactly determine when the bubbles will burst, but they mostly do. This may be a sign that the rally may be nearing the top.

Overall, I am doubtful that corporations will continue to increase buybacks, since stocks are no longer. Hence, corporations may not scoop up their shares as aggressively as they did in recent years the next time the stock market sells off.

If the economy does not improve, the stock market may become fragile because slowing stock buybacks may lessen the demand for risky assets. A small equity sell-off could potentially turn into a double-digit correction. So, it may be prudent not to chase the current rally.

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More from MoneyShow.com:

Sharing the Wealth

Financial Sector Buybacks

The Benefits of Buybacks

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