Shrinking Stock Market

Posted on: by .

The markets have rallied off the lows after the Labor Report, realizing there is little chance the Fed will hike rates in October. One colleague said it was a brilliant strategy, the Fed talks tough and they will raise rates, full well knowing that the Labor Report was going to be weak. Then they can say, hey we want to raise rates – don’t kill the messenger – it’s the economic data that is bad. Pass the buck, blame game. I found his conjecture amusing and regardless if true, it does play out a great story and spin.

The market bounced off the lows and is now up into the resistance level. Yesterday we saw the sellers step back in around resistance and that put pressure on the market. This morning it looks like it may try again to push up into and through resistance, expect selling pressure to resume however. While we can certainly push through into a break-out, what we really need is a catalyst event. What we are waiting for is confirmation the Fed will not hike rates at the October FOMC meeting. That could certainly jolt the market higher and end rate hike fears. For now the market seems to be stuck in this range and right now we are in the top of the range. I would be cautious of getting long into resistance – for now. The break-out higher WILL come after the Fed confirms NO RATE hikes and offers a more dovish tone in the FOMC statement. In the meantime we could revisit the support areas. Just be patient.

Shrinking Stock Market

For those paying close attention and financial wonks, there is a growing concern about the loftiness of the market and it is not solely based on the Fed’s monetary policy. The concern arises from trillions, that’s trillion with a “T”, in share buy backs since the start of the crisis and QE programs.

Laws of Supply & Demand

Why would this be a concern, some would argue that companies buy back shares when they think their company is undervalued. On the surface and theoretically that may be true, what we need to come to terms with is the LAWS of Supply and Demand and how it shapes earnings and perception.

The stock market is a FINITE market, there is only X amount of shares to buy. The X amount of stock is the Supply. The Demand side of the equation are the investors in the market. The more investors and the more money/credit, the higher it will drive the prices of the limited X Supply.

If one were to REDUCE the supply of stock and if the Demand remains unchanged or increases, it will only further push prices higher.

Since 2009 companies have bought back over $2.4 trillion in stock. That is an unprecedented amount. Prior to the crisis companies bought back less than $25 billion in shares per quarter, today they are buying almost $150 billion per quarter. The reality is the net pool of shares is shrinking at an accelerated rate.

Calculating in the $2.4 trillion in share buybacks alone has accounted for 21% of the market cap rise, which is an enormous amount.

Courtesy of Idiosyncratic Whisk

Earnings Perception

Share buybacks don’t just help increase the stock price, by reducing the float (number of outstanding shares), it also helps earnings perception.

I have frequently mentioned the most important numbers in earnings are the top-line numbers in REVENUE and SALES. It is far MORE important than the bottom line profit and loss. The reason is simple, you want a company to see revenue and sales rise, period. Many times you will see a company with top-line revenue and sales rise, but bottom line profits shrink. This is because the company could be expanding, hiring, opening new stores, investing in research, etc. We shouldn’t be concerned about the bottom line in this case, because the company is investing in the future and the top line growth is heading higher.

The Great Recession saw an interesting phenomenon, in which top-line sales and revenue contracted, but bottom line profits increased. One reason for this was that the company was cutting its costs faster than their top-line revenue and sales were shrinking. So it SEEMED the company was doing better, because it had improving profits. Those not paying attention were FOOLED by the profit and earnings.

When you add SHARE BUY BACKS it super charges earnings and profits, for the uninformed it can fool them further into thinking a company is doing very well.

Here is a simple example:

Company earns $100,000 in revenue and $50,000 in profits. The float is 100,000 shares and it reports .50 earnings per share (EPS) in profit (50,000 profits / 100,000 shares).

The company buys back shares and reduces the float to 75,000 (25% buy back).

The company’s revenue falls from $100,000 to $75,000, but they cut costs and still have a profit of $50,000. The next earnings they report is .66 earnings per share (EPS) in profit. (50,000 profits / 75,000 shares)

That is a big improvement from a year ago.

If we only pay attention to the EPS number and compare it to a year ago and do NOT pay attention to the top-line or the share-buy backs, we make the false assumption that this company is doing well. The reality is the company saw revenue drop 25%, cut costs to keep profits unchanged, and reduced the shares with a 25% share buy-back. The story is NOT good at all.

This is one reason we see stocks with better than expected earnings fall and other stocks with lousy earnings rise. The smart money spends time reading beyond the headlines of the EPS. Yet for the layman and those that only pay attention to the headline EPS, they have no idea why the stock is falling when they had better earnings. In fact they might even BUY MORE shares because they think it is an opportunity. I have even heard a stock broker advised a client to buy more based on the EPS, when the scenario did not look good. Again – paying far too much attention to the headlines and not HOW the headline number was derived.

Real earnings of late, measuring top line revenue and sales, have not been great when looking across the S&P 500. Some have certainly beat EPS expectations, but many are accompanied with forecast slow down warnings.

The big concern is that we have reached an inflection point in which earnings are LESS THAN The dividends and share buybacks. The last time we saw that was in 2008. How long can they run at an inversion?

Courtesy of Market Watch

End Game

Much like the Fed’s monetary policy of ZIRP (zero interest rate policy), bond buying, and mortgage back security purchases, share buy backs can’t continue forever. In fact some have argued there is a direct correlation with Fed’s ZIRP interest rates and share buy-backs. With zero interest rates we have seen a huge growth in corporate borrowing that has only fueled more buy-backs. Ironically if the Fed raises rates, which will put pressure on the stock market, companies may even need to increase their buy-backs to keep growth accelerated. The reason beyond the pressure it will put on the equity markets is that it will impact margin interest (the cost of borrowing money to buy stocks), which will only further reduce demand.

While we are heading into the end game for the Fed, that doesn’t mean they can’t buy more time. QE4 and perhaps other accommodative policies (not yet thought of) can help kick the can down the road. Share buy backs also don’t look like they are going to ease anytime soon. As long as companies can borrow, they can maintain the negative inversion between earnings and net dividends/buybacks, but that can’t last forever. Clock is ticking.

Support & Resistance

INDU 16,800
This is a tipping point in the resistance band. We could get up to 17,000, but expect selling pressure in here. I think 16,400 is short-term support. Be careful taking any hard delta stand in this range. Own Gamma and let your Gamma work.

NDX 4,300
We are going to hover above and below the strike for a while. 4200 and 4400 are in the cards, but do NOT look for a trend yet.

SPX 1900
Much like the other indices we raced back up here, but I suspect pressure coming in at 2000 until we get Fed Dovish comments. Expect 1960 – 2000 for now. VIX is coming off and if we get into the low-mid teens, then the market is under-pricing volatility.

RUT 1140
The Russell is already starting to fade the 1140 area. If the Russell comes off today, expect delayed pressure across the other indices. Look at 1120 as short-term support and 1100 as broad support. Russell could see intra-day pop to 1160 on any strong move, but expect continued selling pressure.

We will not see any trend develop or strong break-out until the Fed FOMC meeting in October, just weeks away. What they do or don’t do and the dovishness of their statement SHOULD set a trend for the market. If no rate hikes and dovish, expect a strong break-out rally.

However, the Fed is full of surprises – don’t be surprised if Yellen, only days after the FOMC statement makes a speech about RAISING RATES again. That would certainly put the brakes on any rally and then we would be in limbo again and waiting for the December FOMC meeting.

3 Responses to “Shrinking Stock Market”

  1. McRocket says:

    Thanks for this…very interesting.

  2. Luana says:

    My thanks, too, for I found it not only interesting but informative, touching on areas I’ve not thought about before. Your articles on the economy, finance and investment affords me insight of the market(s) and manipulation of same I don’t get anywhere else.

  3. [...] distorts the earnings, ironically for the better. In a recent Market Preview, I wrote about the “shrinking stock market” and how this impacts earnings. It is worth [...]