Corporate Stock Buybacks Continue To Distort Stock Valuations
The rally in stocks since the Q1 2009 has largely been powered by corporate stock buyback programs. Organic top-line revenue is only 23% higher during the past five years but the S&P 500 stock index has rallied 300% from the March 2009 intraday low. Corporate management have been aggressive buyers of their own stock despite modest or non-existent sales growth. The cash that normally would have been re-invested in corporate America is being distributed to shareholders via dividends and buybacks, This is a long term detriment to the American business sector and keeps earnings valuations of stocks artificially reasonable. After all, fewer shares outstanding and stable earnings creates the illusion of earnings growth over time.
The data suggests that stock valuations are something similar to San Francisco real estate. Large chunks of San Francisco real estate are built upon "reclaimed" land that was formerly a marsh area. The Marina District and much of SOMA (where Giants stadium is located) has no bedrock. The geological foundation is sand and clay. In the event of a 7.0 earthquake lasting at least 30 seconds, the soil in the Marina and SOMA will liquify under construction foundations. This creates enough instability that buildings and houses will literally slide off of fractured foundations.
The catosrophic damage to construction during such an episode would be quite bad but the greater threat is the fire danger occurring from severed natural gas lines and water mains. The last time a 7.0 earthquake struck San Francisco was in 1989. The Marina District was devasted by collapsed buildings/houses and fires. SOMA was much less developed at that time and was largely a vacant area of WW 2 warehouses. However, geologists have noted that an 8.0 earthquake has hit the Bay Area approximately every 100 years during the past millenium. The last 8.0 earthquake in SF was the famous 1906 quake.
The aggregate appetite of Corporate America for their own shares exceeds the investor frenzy during the dot.com bubble in the laste 1990s. At that time, mutual fund inflows averaged about $330 bln per year. Currently, corporate buyback programs are running at a pace of $500+ bln annually. How much impact has this created on stock returns this year? Now that Q2 earnings season is over, here is a summary of the impact of all those hundreds of billions in stock buybacks, courtesy of Deutsche Bank.
According to Deutsche Bank, in Q2 EPS, or rather non-GAAP EPS, for S&P 500 stocks rose to $29.50, an impressive increase of 7.9% from the $27.23 a year earlier. This follows a not too shabby 4.4% increase in Q1's Y/Y increase from $26.76 to $27.95. The problem, as we showed last quarter in "The Truth About First Quarter S&P 500 Earnings", is that virtually all of this increase is due to non-GAAP adbacks, in effect nullifying the impact of the major drop in shares outstanding as companies scramble hand over fist to issue debt and buyback their float. In fact, as we showed last quarter, GAAP EPS declined 2.2% Y/Y. So what about GAAP Q2 EPS: the answer - a nearly meaningless 1.8% increase, or over four times less than the non-GAAP increase. So how does the GAAP vs non-GAAP change compare for Q1 and Q2? We show it in the chart below.
Finally, now that we can compile the first half data using the first two quarter data for both 2013 and 2014, we can conclusively state that if it weren't for the accounting magic behind non-GAAP, which includes such addbacks as tens of billions in litigation costs for the TBTBF utilities, pardon banks, pension addbacks, and not to mention hundreds of billions in restructuring addbacks resulting from the mass termination of hundreds of thousands of workers who miraculously fail to trickle through to the BLS' own "survey" data, things would hardly be as rosy as portrayed by the sellside. In fact, EPS growth in the first half was either 6.5%... or 0.2%. Depending on whether or not one believes in accounting magic.
Finally, those wondering what the benefit from buybacks to the bottom line has been, here is the breakdown, as well as the EPS growth by sector.
In other words, excluding buybacks, GAAP EPS in the first half would have been negative. Clearly the data suggest that stock valuations are stealthly rich. That being said, there is little incentive for Corporate America to halt their stock buyback programs just yet so stocks are apt to continue to grind higher for the foreseeable future. At some point, however, the cessation of stock buybacks will be accompanied by a very, very nasty sell-off but I wouldn't expect that to occur prior to the S&P 500 flirting with 2,200 or 2,350 at a minimum.
