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The Bull Run’s Magical Matador

January 7, 2019

There’s a clear matador in the latter part of the recent bull market – corporate stock buybacks.

 

Firms buying up their own stocks, sometimes funded by large loans, is a big reason the bull market has lasted so long and could last even longer.

 

Money is cheap, why not use it to invest and profit? The Federal Reserve’s “easy money” policies have been propping up the stock market and made bonds less attractive as a result.

 

When companies buy their own shares, prices usually go up. Most of the transactions occur in the open market and tend to be large. And in classic supply-and-demand style, when fewer shares are available, it makes the remaining ones more expensive.

 

Many folks don’t realize the sheer scope of this activity (a projected $1 trillion in 2018) and the results it has produced. In fact, corporate buybacks have been the largest source of demand for U.S. stocks.

 

The number of shares bought via buybacks is double that of exchange traded funds, which have been some of the most popular investments for years, and six times that of mutual fund purchases.

 

That’s amazing.

 

Buybacks increase share value because any remaining shares have a higher percentage of company control. That sounds great, except external shareholders don’t benefit – management does.

 

Executive compensation is often tied to earnings per share (EPS), a favorite Wall Street metric. Buybacks increase EPS not by increasing earnings, but by reducing available shares – it’s accounting wizardry at its finest.

 

When managerial compensation is tied to EPS, and cheap money can increase EPS through simple purchases, what do we expect to happen?

 

When the next bear market arrives, this activity will likely die off, at least on a large scale. Until then, executives reap the rewards.

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