Days of Stock Market Irrationality Numbered

key stock indicesIn the first 10 months of the year, key stock indices like the S&P 500 have gone up more than 20%. Others like the Dow Jones Industrial Average have lagged a little, but the returns are exuberant nonetheless.

But as this was all happening, we saw the formations of very troubling trends in the fundamentals that drive key stock indices higher. Companies on key stock indices started to show corporate earnings that were nothing but an illusion. They fiddled with their corporate earnings via massive stock buyback programs and cost-cutting to make them look better.

And as we now near the end of 2013, companies in key stock indices continue to do more of what they have been doing for a while: using “financial engineering” to make their corporate earnings look better. But the real gauge of how companies are doing—if you can’t trust their earnings—lies in their sales.

So far, 366 of the S&P 500 companies have reported their corporate earnings for the third quarter of this year, and only 53% of them have reported sales above the expectations. (Source: FactSet, November 1, 2013.)

Consider General Electric Company (NYSE/GE), one of the major companies in the S&P 500. In the third quarter of 2013, revenues for the company declined 2.3% from the same period a year ago. (Source: Investor Relations, General Electric Company, October 18, 2013.) But the company is buying back its shares!

The board of International Business Machines Corporation (NYSE/IBM), another big component of the S&P 500, authorized an additional $15.0 billion for the company’s stock buyback program. The company’s existing share buyback program already had $5.6 billion in it. (Source: Investor Relations, International Business Machines Corporation, October 29, 2013.) What share buybacks do is increase the corporate earnings per share. The higher the amount of share buyback, the higher the corporate earnings per share look.

The fourth quarter has just begun, but we have already started to hear from companies on the key stock indices. They are outright worried. As of November 1, 79 companies on the S&P 500 have issued guidance about their corporate earnings; more than 83% of them expect their corporate earnings growth to be negative! (Source: FactSet, November 1, 2013.)

As I continue to say in these pages, the days of stock market irrationality are numbered and eventually, reality will strike key stock indices. My take is that the longer the stock market rally continues, the bigger the fall is going be. Stock prices have skyrocketed and investors have taken on too much leverage. A little market correction can lead to a much bigger sell-off. Be very careful with the stock market!