One of the more troubling trends in the markets has been the sky-high valuations for companies on Wall St despite a number of reasons to be cautious. Corporate earnings and the broader economy have both been characterized by weakness thus far this year.
This brings us to at least two major warning signs for U.S. equities that investors would do well to keep a close eye on: 1) a collapse in share repurchases, also known as stock buybacks; 2) widespread uncertainty regarding the Federal Reserve's interest-rate policy ahead of the presidential election on November 8th.
Between 2013 and 2015, the rate of stock repurchase agreements skyrocketed to levels not seen since prior to the financial crisis in 2007. In fact, during the second quarter, this trend had continued, with nearly 380 companies combining for almost $170 billion in buybacks, the highest since the fourth quarter of 2007.
However, as the chart above indicates, the third quarter is all but certain to show a precipitous drop-off in the total value of these stock repurchases as well as the number of firms engaged in such buybacks. Before Q3, it seemed that the pace of repurchases was poised to threaten the annual record.
At the end of last year, a fair amount of editorial breath was spent warning that stock buybacks were being pursued for misguided reasons. When a company uses this mechanism to purchase its outstanding shares of common stock, it is indicating that it believes its stock valuation is too low. (Repurchases tend to boost equity prices.) Of course, that money is also being diverted from other options, like investing in research and development. In one sense, it would seem that the unjustifiably high level of stock values is simply buoyed by these buybacks.
Nonetheless, the important point is that when buybacks fall off a cliff, the stock markets have a tendency to follow lower. Financial Sense contributor Kurt Kallaus makes this very warning about stock buybacks. He also zeroes in on the impact that monetary policy could have on Wall St:
"If the Fed was hesitant to raise rates all year, it’s hard to fathom how they can justify rate hikes at this juncture with these weak data points and just prior to a murky US election. Such logic has prevailed in preventing rate hikes in 2016 thus far, but there is often a lack of clarity in the messaging from our central bank."
His observation about a "lack of clarity" from the Fed is an understatement. For the uninitiated, this seems like pure dysfunction. In fact, such "Fedspeak" is intentional. It helps keep markets stuck in neutral (or even rising) when the truth about the Fed's inability to normalize monetary policy would otherwise cause a panic.
The Fed will continue to talk up the narrative of rate hikes while it dares not raise interest rates prior to the presidential election. However, after November, don't be surprised if the stock markets tank when it becomes clear that there are only two possible outcomes: Either rates go up and the "free ride" ends, or we all realize that the emperor has no clothes.
The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.