Stocks are on a sugar high

Stock prices are going up in part because companies limit the supply through buybacks. It’s a “sugar high” that’s bound to end.

The superstar tech companies – the apples of Wall Street’s eye – are absolutely flushed with cash.

Google’s shrugged off the two record-breaking fines it got from the European Commission like a footballer on £200,000 a week might receive a £100 speeding ticket.

Apple and Amazon have been ordered to pay the tax man the money they owe him, yet still they’re left with more money than they know what to do with.

Pay taxes? How preposterous!

Give employees a pay rise? Don’t be absurd!

No, they’d rather splash the cash on themselves.

Like Narcissus who fell in love with his own reflection, companies can’t get enough of themselves. They’re spending bags of money on repurchasing their own stocks.

Goldman Sachs believes stock buybacks will hit $1 trillion this year.

Companies buying up their own shares, which pushes valuations higher, plasters over the fact that investor confidence in the market is waning.

Stock buybacks have propelled the market higher but this isn’t meant to last forever.

The bull market is fake news

The present bull market is, in the words of Donald Trump, “fake news”.

Not so much in the sense you can’t believe the finance section in your newspaper. The valuations are what they are.

But it’s “fake” in the sense that the momentum pushing stocks upwards isn’t driven by rock-hard fundamentals.

Put another way, there’s no logic behind this bull market.

Neither the economy nor the companies are presenting figures that support their sky-high valuations.

The US economic recovery has been rather weak at 3.8%. A GDP growth of 6.2% on average is the historical norm, writes Luca Paolini, chief strategist at Pictet Asset Management on LinkedIn.

True, Apple and Amazon beat market expectations when they published their second quarter figures, but not to the extent that it should have pushed up their shares the way it has.

And as I wrote last week, it’s mostly been the good performance of a few superstar tech companies that saves the market from going down. The performance of the vast majority of stocks isn’t that hot.

Meanwhile investors are acting off the canary in the coalmine. They’re not sticking around any longer and have been selling a record amount of stock-based funds.

“Individual investors head to the sidelines amid fears that a global trade war could thwart the substantial momentum the US economy has seen this year,” writes CNBC’s Jeff Cox.

If fear is making individual investors sell out of investment funds, what then is causing stock markets to go higher?

It’s the companies themselves.

They are swimming in money. More than they can (or wish to) invest anyway.

Since they’ve put a lot of effort in sheltering trillions in offshore tax havens, and they’re not willing to spend that money on higher wages, they have decided to use the money for stock buybacks.

Granted, it’s doing wonders for the stock market at the moment. But for how much longer?

Sugar high

From the looks of it, the bull market has been driven by a shrinking supply of shares rather than rising demand.

US companies spent $433.6bn on buying back their own shares in Q2 after already spending $242.1bn on buybacks in Q1.

Apple alone bought back $100bn worth of its own stock this year…

To be sure, companies taking a chunk of their shares off the market can have the effect of pushing the price of remaining shares higher.

But it’s not a healthy, sustainable way to drive stock prices.

Explains US Senator Elizabeth Warren, a rumoured candidate to take on President Donald Trump in 2020:

“Stock buybacks create a sugar high for the corporations. It boosts prices in the short run, but the real way to boost the value of a corporation is to invest in the future, and they are not doing that.”

She hits on the temporary effect buybacks have on the market. They may be a way to boost valuations but they don’t have a lasting effect.

It puts today’s bull market in a whole different light.

Stock buybacks are an important driver behind rising stock prices. In fact, Luca Paolini estimates buybacks account for about 30% of the bull market.

Companies won’t be able to keep this up for long.

“Stocks right now are hanging by a thread, boosted by a bonanza of corporate buying unrivalled in market history and held back by a burst in investor selling that also has set a new record,” says Cox.

Investors seem to be moving away from the equity markets and into safer investments like bonds. It’s a sign that investors currently have only a limited appetite for risk.

“This has been probably the most unloved bull market in history,” argues Paolini. 

“Companies buying back their own shares is the only thing keeping the stock market afloat right now,” warns Cox.

Companies have been high on their own stocks. Stock buybacks have pushed valuations higher and higher without it being merited on economic performance.

But every sugar high is followed by an inevitable sugar crash.

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