Pay No Attention to the Man Behind the Curtain or The Source of Record S&P 500 Company Earnings

We have been concerned about the recent record breaking performance of the U.S. stock market given that fundamental economic data does not support the surge in prices that has happened during the prior several months. However there has been one compelling metric that has provided some support for this dramatic increase and that is record S&P earnings. We have previously shared in our quarterly update a graph illustrating the significant rise in corporate profits during the more recent time period. Our presumption has been that these record profits were driven by productivity gains and low interest rates because revenues have not risen so dramatically but low and behold the magic of financial engineering is the cause of record earnings. The graph below succinctly conveys the source of record earnings, corporate share buybacks. If a company has flat earnings but buys back shares their earnings per share increases because there are less shares outstanding to divide earnings into. Voila, buy back shares and your earnings increase.

Please follow this link to an article that provides an in depth analysis  and explanation of this blatant manipulation of earnings.

S&P Operating TTM EPS

Apple computers recent $17 billion bond offering typifies what companies are doing and why they are doing this. Corporations motives are not nefarious but with interest rates at records lows, strong investor demand for quality debt, big profits stuck overseas due to  tax liabilities and  shareholders desiring a piece of Apple’s massive cash hoard, buying back shares is a no brainer for a public corporation. Apple has allocated $60 billion toward share repurchase and dividend payments through 2016. The share repurchase will save Apple $1.5 billion annually in dividend payments and if earnings are flat for the month of September it will increase earnings by .25 per share. Shareholders may fair well in the long run but those Apple bond investors who bought 30-year bonds on April 30th are down nearly 8% in less than one month, ouch.

Sustainable economic recoveries are built on a foundation of solid economic growth resulting from investments in innovation, capital formation, revenue growth and organic profit growth not financial engineering and massive monetary intervention. One would think that corporations are good at timing their share buy backs but in fact their track record is awful.

Buybacks

Meanwhile, NYSE margin debt just hit a record high of $384 billion, a level not seen since March of 2007.

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