Buybacks: Free Lunch or Warning?

03/09/2015 9:00 am EST

Focus: STOCKS

Alan Newman

Founder, Crosscurrents Publications, LLC

The current mania is unlike any we’ve seen in decades as the investing public was badly burned in the previous two manias and has elected to be only minimally involved, explains Alan Newman, editor of CrossCurrents.

Cumulative inflows into domestic equity funds have continued to decline throughout much of the bull cycle. This has been a most unusual bull market, the first we’ve encountered in history that did not include the public in their traditional role of lemmings, marching obediently off the cliff.

So, why has the bull market remained intact? Astonishingly, the lemmings in this mania have been the constituent companies of the S&P 500 Index buying their own shares.

While $443 billion has flowed out of domestic mutual funds since the beginning of 2010, share buybacks by corporate treasuries have much more than made up the difference. Last year alone, it is estimated that the S&P 5000 companies bought back $565 billion of their own shares.

How much is $565 billion? Despite the enormous participation by the public in the last two-and-a-half years into the manic peak of March 2000, net inflows for the final 30 months of madness fell shy of what corporations have spent for their own shares in only the last 12 months.

Clearly, it is impossible to estimate how much more corporations are willing to commit to their own shares to drive prices still higher.

Share buybacks tend to reduce shares outstanding, which equates to higher earnings per share, which equates to higher share prices. In the final analysis, buybacks wind up as a cash generating machine. It’s possibly the greatest example ever witnessed of a free lunch.

The persistence of the trend has resulted in a nearly complete abandonment of the bear camp. In the past, there have been numerous occasions in which bears have fallen below 20% for several weeks before a correction ensued, but the current circumstance is beyond anything we have ever experienced.

Bears have been below 20% for 70 of the last 73 weeks. We note with alarm how often a disappearing bear camp is accompanied by a correction.

The extent of overvaluation now borders on the surreal. We continue to suffer through one of the greatest phases of malinvestment the country has ever experienced as corporations buy their own stock rather than invest in the future.

Under the circumstances, we have no alternative but to maintain our bearish view on how it all plays out. We still expect a 20% downside this year.

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