Is the Stock Market Higher Because of Truth or Fiction?

The fool
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The U.S. stock market has risen a great deal since the low in 2008-2009. By most accounts, the market has more than tripled and now stands at historical highs. What has caused this massive increase in stock prices? Rising corporate profits and a booming economy? Or something else entirely?

Before investigating this question, a quick review of corporate stock is in order. Companies that are “public” (vs. “private”) issue shares of stock for investors and the public to buy. Though some companies do sell their stock themselves, most companies use the services of a “market” or “exchange”, such as the New York Stock Exchange. Once a company issues and sells its stock to the public, they no longer have direct control over the price of their own stock.

After a corporation’s stock begins trading on the open market, the only way a company can control its stock price is through its financial situation, i.e. positive or negative earnings, debt load, earnings forecast, etc. Sometimes other matters may also affect a company’s stock price, such as a new CEO or the announcement of a new product.

However, there is another way a corporation can manipulate its stock price on the open market – and it’s perfectly legal and acceptable; by repurchasing its own stock on the open market.

This action is commonly called a “stock buyback” or a “repurchase”. The idea is simple and based on supply and demand; less shares available for the public to buy equals a higher stock price. Does a stock buyback typically raise the price of a stock? Usually, yes!

According to Bloomberg, since 2009 companies have spent $2.4 trillion of their own money on stock buybacks, much of it using borrowed money. Indeed, corporate debt is now at an all-time high.

The amateur ecoomist
Note: Debt amount on left side of the graph is in “millions” – which translates to corporate debt over $5 trillion dollars.

Why would a corporation borrow money and then use all or a part of it to buy back its own stock? Because interest rates on debt are at historical lows. A corporation borrows money cheaply, then uses the money to buy back their own stock – which then increases their stock price.

Though not all companies use debt to repurchase their own stock in the open market. From 2003 to 2012, 449 companies listed on the S&P 500, used over half of their own profits, $2.4 trillion worth, to buy back their stock. 

Should a corporation use its own earnings or the proceeds from debt to buy back their own stock? Or should they use the money to grow and expand the company – with the possibility of creating more employment and capital creation? That is a question for another time.

The question for today is; how much of the recent stock market rise is the result of stock buybacks (fiction) vs. the increasing financial health of the company (truth)? Hard to say – there are many other variables at play.  However, recent financial analysts and economists have made estimates, one that is as high as 74% of the increase in stocks is due to company stock buybacks.

“Market returns have been driven primarily by buybacks in the U.S.,” Deutsche Bank global equity strategist Binky Chadha writes. While this is likely no great revelation to many professional investors, who pay close attention to stock buybacks, it may surprise ordinary savers that stock-market gains stem more from companies gobbling up their own shares than from fundamental economic activity.” 

So the next time one hears, “..the economy is doing great – just look at the stock market!” recall that a large percentage of the stock market increase is due to stock buybacks, not because of a company’s positive or negative financial results.