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Summary

  • The Black Swan revisited.
  • The hazard of investor hubris.
  • The peril inherent in stock buybacks.

The Black Swan.

A "Black Swan" event leading to a substantial market correction is just around the corner. At least that's what an increasing number of market prognosticators have been saying. With that in mind, I thought it might be useful to you, Dear Reader, if we brushed up on what a "Black Swan" event is. I also gazed a little into my long broken crystal ball and will share a theory with you as to where the next "Black Swan" may come from… and what will be some of the signals of its impending arrival.

The theory of black swan events as developed by Nassim Nicholas Taleb, who happens to be one my favorite authors, is a metaphor that describes an event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight. The educated European of a few centuries past knew there was no such thing as a black swan… that is until the continent of Australia was discovered, along with a new species of swans. You guessed it. They were black. September 11, 2001 was a Black Swan event. It was impossible to think the bastions of capitalism that were the World Trade Center Towers could be brought down by a motley crew of ill-equipped, under-funded, zealous terrorists. But the Towers fell and our world changed dramatically. A not too distant financial example is the 2008-2009 market meltdown. Back in 2007 we all knew property values ONLY went up and were a steady source of increasing equity and could be increasingly borrowed against forever. There were very few people who thought that at some point that trend must stop and possibly reverse. And then Lehman Brothers, founded in 1850, went under. The Black Swan became real.

The Hubris.

Fuhggedaboutit! That was six years ago! Our markets have more than recovered. Our companies continue to report record earnings. And the almighty Fed has tamed inflation and has promised us a long term era of low interest rates and economic growth. The black swans of the past have been considered, prepared for and mitigated against.

Funny thing about black swans, there's always a new one around the corner. And by definition, they're yet to be discovered.

The Theory.

I picked up a piece of my long broken crystal ball the other day and stared into it. Mind you that it's broken and not very clear so what I saw in it must be taken only as theory and not prediction…

What I saw is this: A good portion of the demand for stock in this ever rising market is due to companies buying back their own stock. A LOT of their own stock. And they're just as good at market timing as the rest of us...

Factset Fundamentals posted their most recent "Buyback Quarterly" for Q1 2014 and it had some interesting data.

Quarterly Buybacks Grew 50% Year-over-Year: Dollar-value share repurchases amounted to $154.5 billion over the first quarter and $535.2 billion for the trailing twelve months. The first quarter sum is the third largest amount since 2005, and both the Information Technology and Industrials sectors surpassed peak buyback spending.

and

Information Tech, Materials, & Industrials Increase Buybacks >100%: The Information Technology sector spent the most on quarterly repurchases ($47.4 billion) in Q1, and also showed the highest year-over-year growth in spending (+175.5%). The Materials and Industrials sectors also registered impressive growth in share repurchases (141.7% and 119.2%).

The accompanying graph was eye-catching as well:

(click to enlarge)

You can see that the S&P 500 companies have been on a holy terror in buying back their own shares. And increasing those buyback amounts as Ms. Yellen and her Fed has been tapering QE stimulus bucks.

Corporations have also been using their revenues as well as borrowing cash at current ultra-low interest rates to buy these billions of shares. Sure, they've invested some of that cash into research and some new facilities, but by a great margin, much of that borrowed money has been spent buying back stock.

(click to enlarge)

All while corporate net cash flows are wavering:

(click to enlarge)

So what's up with so much positive EPS growth supporting current valuations? I speculate that at least some measure of EPS growth are artificially inflated due to less outstanding shares. Net cash flow is wavering yet companies are still hitting their numbers. In a wavering cash flow environment, I gotta think that some of that number hitting is not due to positive results but rather that there are less outstanding shares to split that revenue amongst. Leading to (artificially) higher EPS.

As I gazed into my cloudy, broken shard, I wondered: What happens when EPS have to fess up to wavering net cash flows? What happens as the Fed tapers, then company buybacks taper? What happens when interest rates start rising more aggressively and this low rate, Fed fed corporate artificial stimulus drys up? Companies would no longer be able to borrow cheaply so they would stop buying so much of their own stock. Higher rates, real EPS results, decreased share demand leading to less support for current stock prices.

A vicious cycle could ensue. Would this indeed be at least a part of the Black Swan that causes buyers in this market to start selling with markets turning very ugly, very quickly?

Honk?

Honk?

HONK!

But of course, there's no such thing as a black swan.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: The Looming Black Swan