Buybacks: Cheap Market Or Lousy Timing?

Includes: DIA, QQQ, SPY
by: Market Blog

By David Berman

Bloomberg News has an interesting, and certainly optimistic, take on a report from Birinyi Associates. U.S. share buyback activity this year has risen above $450-billion, putting the year on track for the third biggest in terms of buyback activity. The reason, according to Bloomberg: Stocks are cheap!

"U.S. companies are buying back the most stock in four years, taking advantage of record-high cash levels and low interest rates to purchase equities at valuations 15 percent cheaper than when the credit crisis began," Bloomberg reported.

Heck, Warren Buffett is doing it, buying back shares in his Berkshire Hathaway Inc. (NYSE:BRK.A) to take advantage of the fact that the shares have been trading close to book value – so it must be true.

But is it? The idea that stocks are cheap today is a controversial one. Based purely on trailing earnings and estimated earnings, stocks are indeed cheaper than they were, since analysts are predicting record-high earnings in 2012 (assuming the global economy doesn’t come off the rails). But using Robert Shiller’s approach to valuation, and looking at earnings over the past 10 years to smooth out economic cycles, shows that the S&P 500 trades at a price-to-earnings ratio of about 20. That is most definitely not cheap.

Perhaps more important, what is the track record of companies in timing their buybacks to profit from low-priced shares? To its credit, the Bloomberg article does mention this: If this year ends as the third best for buyback totals, it will be behind 2006 and 2007, when the world economy was as the precipice of the financial crisis that would eventually send the S&P 500 hurtling about 50 per cent.

Indeed, some observers have noted that companies are notoriously bad at market timing, buying their own stocks when they are fully valued. It is certainly interesting that companies are spending big bucks to buy back their own stocks these days. But the bullish implications aren’t exactly clear.

Disclosure: None