- American corporations spent $500 billion on stock buybacks in 2013.
- This $500 billion greatly surpassed retail purchases of stock and influenced the markets by adding an enormous source of new demand.
- The only time in history that more money was spent on stock buybacks was in 2007.
- The only other buyer of significance in the markets was the Federal Reserve which has begun to taper.
- The reduction of stock buybacks and the Fed's taper could result in market weakness.
Like many American companies, Walmart (NYSE:WMT) has been aggressively repurchasing its shares in order to boost the share price and show earnings per share growth in excess of net income growth. Over the February 1, 2013 - October 31, 2013 period, Walmart spent a total of approximately $5.8 billion to repurchase 77.9 million shares of its own common stock. This is in addition to the $4.66 billion that the company spent in the same period of 2012 to purchase 70.9 million shares of its own common stock. This buyback has reduced the company's float to 3.293 billion diluted shares outstanding as of October 31, 2013 from 3.4 billion diluted shares outstanding as of October 31, 2012. This is a decrease of approximately 3.15% in the company's diluted float year-over-year. As the number of outstanding shares go down, earnings per share will necessarily increase even if net income remains flat. This is how Walmart was able to increase its diluted earnings per share for the nine-month period ended October 31, 2013 by 5.07% when net income only increased by 1.74% over the same period.
Walmart is hardly alone at using share buybacks to artificially grow its earnings per share and stock price. This is merely another way in which the company serves as a proxy for the American economy as a whole. According to a recent article on Zero Hedge, American corporations spent a total of $500 billion buying back their own stock in 2013. This was the second highest total in history (only 2007 saw a higher dollar volume of corporate buybacks) and roughly half of the amount that the Federal Reserve injected into the markets through open market operations. It is also substantially more than retail investors injected into the markets in 2013. Here is the flow of funds data for 2013 from the Investment Company Institute, broken down by month:
As the flow of funds data shows, only $18 billion was invested into domestic equity mutual funds, defined as funds that invest solely in the United States equity markets, in 2013. This is clearly substantially less than the $500 billion that was spent on stock buybacks in 2013 and clearly much less than the approximately $1 trillion that the Federal Reserve injected into the markets through open market operations. However, there are other mutual funds that include domestic stocks. For example, world funds invest in both U.S. and foreign stocks. Therefore, we must consider the money that flows into these funds as well even though it will not be exclusively invested in the American equity markets. Here too, we see that the amount of retail money entering these funds is dwarfed by the money entering the equity markets through corporate stock buybacks. A total of $142.9 billion of new money entered world equity funds (a category which also includes non-U.S. stock funds such as international funds) in 2013. This gives a total of $160.95 billion of new money that was invested in equity mutual funds in 2013. This is still substantially below the $500 billion that entered the market in 2013 through stock buybacks.
Some readers might object to the use of the flow of funds data to show the magnitude of corporate stock buybacks in the overall stock market. After all, don't retail investors also purchase ETFs and individual stocks? Well, they do but the flow of funds into mutual funds is the best way to gauge the sentiment of retail investors. First, most of the money that most retail investors have in the market is located inside retirement accounts such as 401k and IRA accounts. These accounts, particularly 401k's, tend to be very mutual fund heavy. While IRA accounts are more likely to contain ETFs and even individual stocks, they are still primarily invested in mutual funds of various types. We can see evidence of this just by looking at the size of both industries. According to the Investment Company Institute, mutual funds worldwide held a total of $28.87 trillion at the end of the third quarter of 2013 (the latest quarter for which numbers were available). Meanwhile, the combined assets of all exchange traded funds (ETFs) totaled just $1.675 trillion in December 2013. Retail investors are also not the only ones to use ETFs as hedge funds and other institutions frequently use them to make broad bets on the market. Thus, the mutual fund flows are generally a better indicator of the behavior of retail investors than the ETF flow of funds. As for common stocks, the amount of money that retail investors have invested in individual stocks is minimal compared to the amount that is invested in mutual funds. Therefore, retail holdings of individual stocks can be safely ignored for the purposes of this analysis. There is no source that I am aware of that maintains figures for the exact quantity of individual stocks held by households but one could conceivably arrive at this figure by subtracting the total holdings of all mutual funds, hedge funds, pension funds, and other institutional investors from the total global market cap. Given the size of these funds relative to the worldwide market cap, it is unlikely that total retail holdings make up a significant portion of the market.
The financial markets, including the stock market, operate very much on a system of supply and demand. Basically, when market participants want to purchase more of a particular asset than is currently available for purchase then the price rises to a level that will entice other market participants that own the asset to sell the asset until the buyers obtain the quantity of the asset that they wish to buy. The reverse is also true. When there are more market participants that wish to sell an asset than are willing to buy it then the price will fall until it reaches a level that entices sufficient buyers into the market to absorb all of the assets that the sellers wish to sell. This is probably already well known by most of you that are reading this. The corporations themselves are thus a major source of the demand that has been present in the market due to the sheer size of their buyback programs. The Federal Reserve's $1 trillion per year injections into the markets have also been a major source of the demand that has been driving markets higher, albeit indirectly. This is because the Federal Reserve is directly buying U.S. Government securities from several large banks known as primary dealers. These banks may then invest this money into the stock market. Even if these banks do not invest all of this newly printed money into the equity markets, it is still a source of demand that likely dwarfs the demand of retail investors.
So, what is the point to all of this? Well, when we look at the numbers then we see that the two major factors that have been driving equity markets higher over the last year are the Federal Reserve and the corporations themselves through their stock buyback programs. This has, in fact, been going on for much longer than just the last year but it reached new heights last year as corporations bought back more of their own stock than in any other single year except for 2007. The Federal Reserve and the corporations are responsible for a substantial amount of the buy-side demand in the market, greatly outstripping the demand by retail investors, many of whom are struggling financially as discussed in Part 1 of this report. This source of demand has been responsible for much of the upward momentum that has been seen in the equity markets.
So, what happens when this source of demand begins to exit the market? There are signs that this has already begun to happen. Back in December, the Federal Reserve announced that it would begin to slow its purchases of U.S. Government securities by $10 billion per month and many expect that the Fed will continue to reduce its purchases going forward. If it continues to proceed on this course, then that will remove this important source of demand from the markets. That would leave only corporate buybacks as a source of demand. There is evidence that share buybacks are beginning to slow as well. According to Nikolas Panigirtzoglou of JP Morgan (NYSE:JPM), companies have in aggregate become net sellers of stock in 2014.
It is quite likely that the Fed's tapering combined with the conversion of buyback programs into selling programs has been responsible for much of the market weakness that we have seen in 2014. As I mentioned earlier in this article, 2013 saw the second highest level of corporate buybacks in history. The highest level ever was reached in 2007 and I doubt that any readers of this article are unfamiliar with the market weakness that was sparked when those buybacks stopped. It is likely that this weakness will continue as companies are unlikely to become net buyers of their own stock again as many have reported disappointing results or have warned investors to expect disappointing results. In fact, there have been a record number of such warnings. Walmart itself was one company that made such an announcement, yet another way in which it serves as a proxy for the American economy. In part one of this series, I showed how the number of Americans that are recipients of government benefits, particularly beneficiaries of the Supplemental Nutrition Assistance Program, has skyrocketed since the Great Recession began. The government cut these benefits late last year in order to save itself several billion dollars. Walmart was one store where many of these beneficiaries spent their benefits as it is the largest grocery retailer in the United States. When this cut came, these beneficiaries no longer had the money to spend at Walmart on groceries. Therefore, the company's profit warning came because of a reduction in government benefits. Retail investors have provided a source of demand for domestic equities but it has not been anywhere near enough to replace the reduction of the Federal Reserve's injections and the reduction or removal of stock buybacks. So, without this market demand for equities, it is unlikely that the equity markets will continue to be as strong as they were in the past few years in 2014.