Bearish View on Buybacks

06/11/2014 9:00 am EST

Focus: STOCKS

Dennis Slothower

Chairman and CIO, Alpine Capital Management

The revised GDP for Q0114 was -1.0%, yet the S&P 500 index responded by setting a new all-time high; the disconnect between a deteriorating economy and a soaring stock market is causing confusion among traders and investors, suggests Dennis Slothower, editor of Stealth Stocks.

Strategically, buying value stocks has been the right way to be invested over the past year. As the stock market climbed higher and strayed further away from economic realties, value stocks continued to move higher.

However, real value has become scarce. While the Russell 2000 has rallied and is now above its 200-day moving average, my research is telling me that we are not out of the woods, especially with the economy now contracting.

It is most unusual to see the stock market ignore the weak US economy and continue to move higher. This is in the face of strong headwinds coming from the Fed that is about to taper again over the next two months.

That is why I am cautious about the market over the next quarter. Eventually, something is going to have to give, and the end result is not going to be pretty.

Since the first of the year, the 30-year Treasury bond has been steadily climbing (and the yield is falling). When investors are pouring money into US Treasury bonds over the equity market, it's because they are looking to park money in a safe haven. So, why are stocks going up while, at the same time, bonds are going higher?

Looking for clues, I think I found something. Last month Apple (AAPL) announced a huge share buyback. However, it also did something else, which wasn't as exciting, yet was just as important: it filed a debt offering for as much as $17 billion.

Apple is helping its share price rise by increasing the share buyback and, at the same time, issuing debt in order to finance its dividend to sweeten the stock for income-hungry investors.

And Apple isn't the only company playing this financial shell game. During Q0114, companies in the S&P 500 (SPX) spent a record $160 billion on share buybacks.

And one more thing—corporate profits grew at the “blistering” rate of 1.3%. To spend $160 billion in buybacks and grow earnings by only 1.3% illustrates just how weak our economy has become. Furthermore, there has been a continuation of negative guidance that has become a recurring theme for over a year now.

At the same time, companies within the S&P 500 are becoming more debt-laden. Historically low interest rates spurred companies to issue a record volume of debt securities last year.

What is troubling is that global debt has increased by more than 40% to over $100 trillion since the financial crisis began. It seems everyone is taking advantage of record low rates to bolster their business.

Instead of investing in capital projects, blue-chip companies are buying back shares and increasing dividends. I see this as an accident waiting to happen. If the S&P 500 index continues to creep higher while earnings continue to deteriorate, it will lead to excessive valuations, which, in turn, will set the stage for the next bust.

Meanwhile, the big story in the new homes sales report is that median home prices dropped 1.3% year over year. That was the second year-over-year decline in three months!

If housing continues to crumble, it directly removes a valuable support for GDP growth just as it did in 2008. I've seen this movie before, and it doesn't end well. Given all the crosscurrents in the market and the economy, this is no time to remain complacent.

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