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Sentiment is a wacky thing. Last year, many fretted corporations were spending too much on stock buybacks at the expense of growth-boosting capex. (Not true.) Now, as firms have announced fewer buybacks in 2016, some worry firms aren’t buying back enough of their own shares! Yes, they fear it reflects falling demand for stocks and, paired with recent data showing investors yanking money from equity mutual funds, many fret this saps the demand for stocks—signaling a bull market in its last gasps. This has no more grounding in reality than its predecessors—the bull can keep running just fine, with or without buybacks at all-time highs.
According to TrimTabs Investment Research, companies have announced $261.5 billion in buybacks for the year through May 19, down 35% from the same period last year. The number of companies repurchasing shares has dropped from 45 in 2015’s first five months to 23. But there is no evidence falling buybacks precede market downturns. 2007 was a record year for buybacks. That they fell in 2008 and shrunk further in 2009—as well as a similar trend in 2001-2002— shows steep drops in buybacks follow market downturns. They don’t cause them.
Buybacks are bullish, but they are just one input into total equity supply, which is still shrinking. Nor must they rise, year in and year out, for bull markets to march on. Total supply matters more than any one ingredient. While buybacks are down, so are IPOs, secondary offerings and cash-based M&A—capital markets activity often sags when markets don’t do much. But as long as supply is shrinking, even if demand is simply flat, it’s bullish. This is Econ 101. Plus, let’s not overstate the drop. 2015 was a banner year, and 2016 isn’t even half-finished. Beware using straight-line math to predict the future. Buybacks are still on track to be quite high this year, whether or not they set a new record.
Stock buybacks are a supply driver. When firms buy shares, those shares are off the market. They might as well not exist. Yet buybacks are often seen as a source of demand, because they involve purchases. This leads to the inevitable presumption that high buybacks mean high demand—as well as the parallel worry that if buybacks are up while equity fund flows are down, companies must be the only source of demand. This fear has circulated regularly in recent years. But it is flawed: It doesn’t account for investors—retail and institutional alike—buying individual stocks and ETFs.
Fund flows show only what one slice of investors do with one investment vehicle. They ignore what folks do with the proceeds of those sales as well as what non-fund investors do. Every share sold, by definition, is a share bought. 790,630,249 shares traded hands on the NYSE on May 26.[i] That is 790,630,249 shares sold. And 790,630,249 shares bought. The NYSE’s dollar volume over the last 15 trading days, $462.5 billion, dwarfs the amount spent on buybacks year to date.[ii] Clearly, there are many, many, many, many buyers, irrespective of what companies are doing with their piles of cash.
At extremes, mutual fund flows can be a sign of sentiment. But they don’t drive prices. It is actually mathematically impossible for them to do so. Because every transaction has a buyer and seller, money coming in and money going out always cancels. When you buy a stock, you don’t buy it from the store where it sits on a shelf looking pretty. You buy it from another investor—a person, pension fund, mutual fund, company, bank, robot, what have you. Market-makers bring you together and ensure the shares and money trade hands. The money you pay doesn’t flood into the market. It floods into the seller’s pocket (or hard drive, or whatever). That is how it has always worked. Moreover, flows are backward looking, and there is no telling what investors might do with money they actually did withdraw from funds and hold in cash.
So how do prices rise and fall? Simple. Buyers bid. If buyers aren’t biting, sellers drop prices to entice them. If there is competition, buyers bid up until they win. The stock market is an auction! Demand is simply investors’ willingness to pay more for each share. It doesn’t depend on some high number of would-be buyers with fists full of loot. Bidding wars can happen with as few as two people. They can also happen with no new entrants to the marketplace. Susie Q can sell one stock at the market rate and use the proceeds to bid another higher. Multiply that action by about a few hundred million, and that’s how prices rise.
Some make a more philosophical argument, claiming falling buybacks signal companies are losing faith in their own prospects and the good time must therefore be over. After all, if a company thought its shares were a good buy and set to rise, it would, you know, buy them. And who knows the company’s potential better than its own execs! But this doesn’t wash. Firms may reduce buybacks in order to raise R&D or capital investments (hey, that should satisfy those buyback critics!). Or they might fund mergers in an attempt to increase shareholder value. Or they might elect to return cash to shareholders via dividends instead. Or maybe they simply have fewer employee stock options to offset. Any or all of these are possible.
It’s also possible some firms simply don’t have the resources at the moment, which 2015’s trends may hint at. Buybacks were weakest in the struggling commodities sectors, which face falling earnings and rising borrowing costs. Energy buybacks fell from almost $41 billion in 2014 to around $15 billion last year as cratering oil prices crushed revenues and net profits. Materials companies completed roughly $16 billion of buybacks in 2015, down from over $28 billion in 2014. In healthier sectors like Consumer Discretionary and Health Care, buybacks grew from roughly $82 billion and $60 billion, respectively, in 2014 to $92 billion and $70 billion last year. The Technology sector—dominated by mega cap firms flush with cash—accounted for over a quarter of all buybacks with $150 billion in 2015 (barely below 2014’s $154 billion). Big Tech firms are also among those with new/expanded buyback programs this year.
We aren’t saying all companies are in perfect shape. But overall and on average, corporate America is much healthier than folks give it credit for. The latest data from the US Bureau of Economic Analysis show broader corporate profits and net cash flow (funds on hand to invest) rose in Q1. Firms are well-positioned to invest and return cash to shareholders, whether through buybacks or dividends. That few see this and instead try to have it both ways on buybacks is a sign sentiment remains overly skeptical. This, combined with continued positive fundamentals, should mean the bull has plenty of life left.
[i] NYSE, as of 5/27/2016.
[ii] Ibid. Dollar volume, 5/6/2016 – 5/26/2016.