Why Corporate Earnings Have Yet to Collapse
As the key stock indices, like the S&P 500, move towards their pre-financial crisis highs, a popular trick for increasing per share earnings is becoming even more popular—companies are buying their own shares to prop up earnings.
Call me a skeptic, but when I see S&P 500 companies buying back their own shares, I think two things: 1) companies are scared to spend their cash elsewhere; and 2) they are pushing per share earnings up, reducing the amount of shares in circulation as opposed to recognizing real earnings growth.
If a company has one million shares outstanding and earns $1.0 million in profit, corporate earnings of this company would be $1.00 per share. Now, if the company buys back 50,000 shares and earns the same profit, earnings per share (EPS) goes up to $1.05—an increase of five percent.
As an example, Safeway Inc. (NYSE/SWY), an S&P 500 company, reported it earned $0.94 per share in the fourth quarter of 2012. But the company’s earnings were much lower if you consider its share buyback. Over the quarter, this S&P 500 company spent $1.2 billion to buy back its shares, boosting per share earnings by $0.17. (Source: Market Watch, February 21, 2013.)
But Safeway isn’t the only S&P 500 company involved in buying back its own shares. Like many other companies, Texas Instruments Incoporated (NYSE/TXN) is using a massive amount of its cash holdings to buy back its shares. The company just announced that it will purchase another $5.0 billion worth of its own shares, bringing the repurchase total to $8.4 billion. (Source: The Globe and Mail, February 21, 2013.) While announcing its fourth-quarter corporate earnings, the company warned investors about fluctuating demand for its products due to economic uncertainty.
Other big names in the S&P 500 are taking similar actions. In the fourth quarter, The Coca-Cola Company (NYSE/KO), Pfizer Inc. (NYSE/PFE), and General Electric Company (NYSE/GE) all announced that they were planning to buy back $10.0 billion worth of shares each. (Source: Chicago Tribune, January 27, 2013.)
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In the first nine months of 2012 alone, S&P 500 companies spent $299.8 billion to buy back their own shares!
Dear reader, what this all tells me is very simple. Businesses, just like the individuals in the U.S. economy, are scared. They are not making investments, which create jobs; rather, they are buying back their shares to make their corporate earnings look better than they actually are.
Funny enough, as companies on the S&P 500 continue to buy back their shares, optimism among investors seems to be increasing. I saw one stock advisor forecasting significant upward moves in the key stock indices, suggesting the Dow Jones Industrial Average will reach 20,000 and the S&P 500 will reach 2,500. But I see the road ahead in a very different light…and that’s a road that includes a stock market moving lower, not higher.
Quantitative easing and the loose monetary policy of the Federal Reserve may have been needed back when the financial system was on the verge of collapse, but could the easy-money policies of today come back to bite investors tomorrow?
Here’s what James Bullard, President of the Federal Reserve Bank of St. Louis had to say regarding quantitative easing: “These are untested policies. It’s not clear how it will end… So because there’s uncertainty about that we’d rather not do more than we have to.” (Source: Saphir, A., “Markets on edge as Fed officials differ on bond buying,” Reuters, February 21, 2013.)
The fact of the matter is that the quantitative easing initiated by the Federal Reserve has fallen short of its expected outcome.
As the Federal Reserve continues to create more money (currently printing at the rate of $85.0 billion a month and keeping interest rates near zero), inflation isn’t the only problem in our future. Asset bubbles are forming.
Investors chase the highest return. We all know this.
But with the Federal Reserve keeping interest rates artificially low for so long, it could be causing investors to take greater risk in pursuit of higher rates of return. For example, in 2012, companies issued $274 billion worth of junk bonds, which by their very nature are higher-risk default bonds. That amount was 55% higher from a year earlier, according to Dealogic. At the same time, the yields for these kinds of bonds have fallen below six percent. (Source: Wall Street Journal, February 20, 2013.)
Turning to the stock market, it’s impossible to determine just how much the Federal Reserve’s easy-money policies have contributed to bringing the stock market back near its record high. But if I had to guess, if it were not for the Fed’s quantitative easing programs, the stock market would be much lower today. For one, if the Fed didn’t take questionable mortgage-backed securities off the books of big banks, banks would still be struggling today and their stock prices would be much lower.
Let’s face it. We have a stock market rising in a period when corporate earnings growth has collapsed, consumer spending is not growing, and the U.S. economy is contracting. How can that be?
Just think what will happen if the Federal Reserve starts to take its monetary policy the other way, raising interest rates and pulling back on money printing as inflation becomes out of control? Such actions will cause bond prices to collapse and the stock market to decline.
The longer the Federal Reserve keeps doing “the same thing,” the harsher conditions investors will face. If something doesn’t work the first time, second time, or third time, chances are that it won’t work at all. Quantitative easing is becoming troublesome now for the U.S. economy, especially for those who are heavily invested in the bond market. I see a perfect storm forming, as the Federal Reserve’s quantitative easing policies have gone on far too long.
Where the Market Stands; Where it’s Headed:
Let me put it in a nutshell for you: overbought and overpriced. That’s how I would classify today’s stock market. Let the calls for new stock market highs march on. I continue to believe that we are being set-up for a big fall in stock prices.
What He Said:
“Over-built, over-speculated, over-financed and over-done. This is the Florida real estate market right now. For those looking to buy for personal use or investment, hold off! The best deals are yet to come. I continue with my prediction that the hard landing in the U.S. housing market, which is now affecting lenders, will have significant negative effects on the U.S. economy.” Michael Lombardi in PROFIT CONFIDENTIAL, April 3, 2007. Michael started talking about and predicting the financial catastrophe we started experiencing in 2008 long before anyone else.