Buybacks the Last Trick in the Magician's Bag to Pump Earnings and Minimize PE Ratio

The WSJ says "Stocks Regain Broad Appeal." They say 'individual investors are piling into stocks' again. What are they smoking? It must have been a slow news day. The brokers will tell you that Joe Retail is not in the market. Sure, there are 401 k investments ongoing but overall, the retail investor is not in the market. Spurts in positive action, such as late last Friday, help boost the inflow numbers, since office workers, especially tech workers, look forward to the weekend and with the melt-up in stocks some of these folks surely chased the bid, but overall, Joe Sixpack is drinking his six pack rather than actively trading. The reason this is interesting is that the necessary amount of sucka's and bagholders are actually not showing up for the hedgies and institutionals to distribute stock. Therefore, when you are looking around for the bigger fool, and cannot find one, it's you.

Over the last year, top line revenue numbers are flat to lower for most companies. For the current earnings season, only 52% of the companies reporting have beaten the top line revenue estimates when at least 59% and more would be expected simply to meet the average expected historic threshold.  The earnings are the 'mother's milk of stock investing' as Mr. Kudlow will quip on business television, and he is correct. Companies must meet the EPS numbers each quarter, it is imperative, and they must show quarter-on-quarter and year-on-year comparison beats. But when sales are in the tank, companies must pursue other means to meet their sacred EPS targets. First, is expenses. Time to lock the supply cabinet doors, tell the employees to bring their own supplies. Also, no more free coffee and soda. Further, using the postage meter to mail your bills is no longer permitted. And the icing on the cake, color copies are not permitted without the administrative assistants approval. Of course, these items are meant in a comical light but you get the picture. Companies cut until they cannot cut anymore. The lower expenses allow the earnings to increase.

Second, the employees. There is no larger cost to a business than the employee. Walking down the cubicle aisles with a scythe will help a company meet EPS lickity split. Axing employees immediately boosts the bottom line EPS through efficiency. Plus, when the other employees see the heads lying on the carpeted floor, they refrain from giving lip, and instead agree to work weekends for free and keep their mouth shut to simply keep their job. These management tactics help meet EPS but the company is reduced to its bare-bones skeleton crew, also known as the core. They congratulate each other since they are the key employees but all that gets them is working 80 hours for 40 hours pay. Once the company is at its core, it cannot cut anymore without closing the doors. Now what? Buybacks. If the number of shares are reduced, the denominator of the EPS (earnings per share) ratio decreases and the EPS number increases. Voila.  The magician's bag is full of tricks, however, this is likely the last trick in the bag.

If 10% of the stock is reduced through buybacks, the EPS will increase 10%. Thus, say a company targets an EPS of 40 cents per share. The Wall Street game is to beat by a penny at 41 cents per share, but if the 10% example holds, and if the company actually did not buy back shares, the EPS would have been 36 or 37 cents per share, a miss, not a beat. That would not have made for happy investors.  Buybacks are an accounting gimmick and come in handy as the hype in the markets reach a bullish crescendo and the hedgies and institutionals can distribute their stock to Joe Sixpack, Ma and Pa Sucka and Aunt Ethel Bagholder, just before the drop. However, as discussed above, perhaps this time the retail investors are not as dumb as they look. Maybe this time the big boys will have to turn on each other when the music stops since there's not enough sucka's to go around this time. Another dirty secret of buybacks is that approximately 3 months after any company announces a buyback, the stock is typically lower, not higher. The initial pop occurs on the announcement but as the weeks play out the air will deflate out of the buyback bubble.

The Fed is the markets. The easy money has pumped markets higher for over 4 years. It is only a question of how much artificial fluff exists under the equity markets. When the EPS rises with the buybacks and other magicians tricks, the PE stays artificially low. The RUT (small caps) is already 20-ish and higher, by no means low, it is actually stretched indicating the need for a pull back, but the SPX and Dow hover around a 15-16 PE area with the average in the 14-15 area, thus making the case that stocks are not overpriced, nor underpriced, instead they are just right at a Goldilocks equilibrium. As the narrative above illustrates, however, if you take away the buybacks, and the number of companies performing buybacks is huge, the EPS numbers would not be as happy and the PE's would be higher. So what does all this wind bag market commentary tell you? The last magicians trick is out of the bag; even the rabbit is out of the hat and has left the building. Do not let the average PE values lull you into thinking that the markets are average-priced or underpriced since the broad markets are likely far more overpriced than anyone realizes.

Note Added 11/19/13: More and more analysts and pundits are now commenting on how earnings are pumped by the buybacks as illustrated above. The buybacks are pursued due to the Fed's easy money policies. Earnings are only met by layoffs and operating with bare bones staff while using low interest rates to finance buybacks. There is no actual growth in this scenario. This tells you that stocks are likely far more overpriced than anyone realizes.