In the mainstream media’s incessant search for anything that resembles a financial market mania, there is a new candidate being talked about. The corporate share buyback trend is now being touted as a “bubble” by certain of the mainstream press. In today’s commentary, I’ll explain why no such bubble exists and why, to the contrary, investors should assume that a bubble hasn’t even started yet. As we’ll discuss, the market’s current investor sentiment profile is actually conducive to significantly higher equity prices before anything like a bubble appears on the horizon.
An article appearing in a recent edition of The Washington Post by Steven Pearlstein caused a stir among some investors who share his concern. Specifically, he writes that “the mother of all credit bubbles” is upon us. The article compares the current buyback trend with the housing market craze of 2006, just before its implosion. Pearlstein writes concerning buybacks:
[G]iant corporations [are] using cheap debt — and a one-time tax windfall — to take cash from their balance sheets and send it to shareholders in the form of increased dividends and, in particular, stock buybacks. As before, the cash-outs are helping to drive debt — corporate debt — to record levels. As before, they are adding a short-term sugar high to an already booming economy. And once again, they are diverting capital from productive long-term investment to further inflate a financial bubble — this one in corporate stocks and bonds — that, when it bursts, will send the economy into another recession.”
Given that the mainstream media have a penchant for exaggerating the significance of anything pertaining to the financial market, we must surely take the above quote with a giant grain of salt. But what if Pearlstein’s argument is correct and there really is a buyback bubble? If there is indeed a bubble now underway, how can we definitely identify it? To answer these questions, we need look no further than the last time the U.S. experienced a financial market bubble. That, of course. was none other than the housing market mania of more than 10 years ago.
There have been many attempts at formally defining bubbles. Most, if not all, these attempts fall short in some way or another simply because a bubble is an event based largely on mass emotion – something which defies technical classification. Whenever a bubble makes its (rare) appearance, you know it’s a bubble because everyone you know is obsessed with it and can’t stop talking about it. Bubbles capture the collective imagination of the masses and become the all-inclusive, completely obsessive focus of the financial market. Almost everyone becomes a participant and tries to get a piece of the action as runaway greed becomes the predominant emotion among investors.
Is runaway greed anywhere in evidence among retail investors today? If you take a serious look around, you’ll have to conclude the answer is “no”. Most investor sentiment polls, including those which poll the sentiment of financial advisors and fund managers, show that participants are anything but exuberant. Instead, these polls show that most investors are relatively subdued and restrained in their feelings about the stock market.
For example, shown below is the Bullish Consensus survey which shows that investment advisory services are less than enthusiastic about the stock market. Here’s what the Consensus poll looks like as of last week. From a contrarian perspective, this has helped keep the stock market buoyant based on the contrarian assumption that a conspicuous absence of bullish advisory sentiment reflects strength in the stock market’s “wall of worry” which every bull market needs to survive and prosper.
History shows that bubbles aren’t possible without widespread participation among small investors. It’s highly questionable that anything like a “bubble” mentality can exist strictly among institutions while retail investors remain relatively disinterested. After all, bubbles are characterized by runaway stock prices, which in turn are created by the combined purchasing power and fueled by the enthusiasm of the masses of retail investors. According to Federal Reserve data referenced by CNN, barely one-third of American families in the bottom 50% of earners own stocks. Moreover, only about 45 percent of private-sector workers participate in any employer-sponsored retirement plan. With so little public participation, there can be no bubble.
Another self-evident proof that the corporate buyback trend isn’t contributing to a bubble is that the buybacks are resulting in a supply reduction of shares in publicly traded companies, a fact that the Washington Post article specifically mentions. With a diminished supply of corporate shares, the likelihood of a collapse is also diminished. One of the hallmarks of a bubble is the expansion, not contraction, of public shares. As the public’s appetite for equities increases during a true bubble, the purveyors of equities do everything they can to increase share counts. This includes stock splits, IPOs, and basically issuing new shares any way they can. The resulting increase in the supply of stocks contributes to the collapse when the bubble reaches the outer limit of its expansion. When participants realize the bubble has burst, there’s a rush to the exits as stocks are dumped onto the market which only feeds the downside momentum of share prices.
With so little of the public involved in the stock market, and with a diminished supply of stocks, how can there be anything like the housing market bubble of the early-to-mid 2000s or the Internet stock bubble of the 1990s? The answer to that question is obvious. There is no bubble right now in the U.S. financial market. Instead, the fundamental and technical condition of the stock market is far stronger today than it was during the previous bubbles just mentioned.
But let’s play devil’s advocate for a moment. Let’s assume that a credit-driven bubble actually exists right now. How can we know when it’s vulnerable to bursting? During the run-up to the housing bubble collapse in 2007, one of the most obvious signs that the U.S. stock market was vulnerable to collapse was the fact that stocks making new 52-week lows were increasing for weeks and months on end. Not only were the number of NYSE stocks making new 52-week lows well above 40 for a period of months – a sign of an unhealthy market – but the all-important rate of change (momentum) of the new highs-new lows figure was declining for most of 2007. Shown below is what the momentum of the 52-week new highs-new lows indicator looked like during the fateful months of 2007 immediately prior to the credit crash.
Now compare this indicator with the current 52-week new highs and lows shown below. The following graph reflects the current internal condition of the stock market. As you can see, it’s clearly rising and is the picture of excellent health. It stands in total contrast to the 2007 bearish internal trend which was characteristic of a bubble about to implode. The 52-week new highs and lows is always the first place investors should look for signs of weakness in the broad equity market since the highs and lows reflect incremental demand for stocks better than any other indicator. And incremental demand is what determines the overall direction of stock prices in the foreseeable future.
In conclusion, the media’s latest attempt at scaring investors into believing that another bubble is upon us is without foundation. When the U.S. stock market is truly beset with another bubble, it will be plain to see without the need for explication. Widespread participation and unrestrained enthusiasm for equities are the indisputable hallmarks of a true financial market bubble. Without these attributes, bubbles simply don’t exist.
On a strategic note, in light of the market’s strong condition, I continue to recommend that active investors maintain a firmly bullish stance and optimistic attitude toward equities. Selective purchases among the stocks showing definite signs of relative strength are warranted, including leading tech sector, retail, and transportation sector stocks as discussed in recent commentaries. In particular, investors should continue to focus their attention on the tech sector.
Disclosure: I am/we are long XLK, HACK, IYR.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.