More Explanation Of The Rally

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Includes: DIA, QQQ, SPY
by: Scout Finance

Summary

The rally has been stronger than I expected.

The rally has been boosted by share buybacks.

The share buybacks will slow as companies enter their blackout period.

Looking back at the market from 5 years in the future, investors will likely not understand the point of this article. Why explain the small upward movement in the midst of a bear market? Why even bother explain the past move in the market if it is much smaller than the downdraft to come? It's partially to maintain objectivity. The reality is my prediction for a market decline have been mistimed. I have been able to do fine in my personal account with my short of Chipotle paying off, but it was easy to read the previous posts and lose money investing based off of them. Therefore, I will attempt to give a further explanation of this recent rally. I will maintain my belief in the recession story until the data changes; it has only gotten worse.

The beginning part of this rally was caused by highly shorted stocks being covered by investors who shorted at the bottom in February, meaning they were squeezed. You can see from the chart below that the earnings picture has gotten worse which is a large divergence from the recent rise in the S&P 500. Part of this divergence may be due to the Fed's open mouth policy change which was the projection to raise rates by 50 basis points instead of close to 100 basis points this year.

The follow through of the rally has come from stock buybacks. ETFs and mutual funds have withdrawn $40 billion from S&P 500 firms, while the firms themselves purchased $165 billion of their own shares since January. This $225 billion gap is the largest on record.

This is a problem because buybacks are a negative signal to the market. You would think buybacks are great for stocks, but they actually signal that the firms have run out of new business initiatives to invest in. If a firm has extra cash because it is at the peak of the profit cycle, but management sees no new opportunities, it will use the money to re-purchase shares.

As you can see from the chart below in the previous cycle buybacks increased a few quarters after net income started to decline. Net income is again starting to decline and buybacks are still increasing. If the trend of declining earnings continues throughout the year, which it should based off of the cycle rolling over, the total buybacks will be forced to decline causing a stock market crash.

Moving towards the intermediate term, the buybacks will slow down in the next few weeks as firms enter their blackout period which is the period prior to earnings where firms cannot buy back stock as they become aware of their quarterly earnings. It may have an even greater effect than it has had previously as you can see in the chart below as the percentage of buybacks of the total investment in the market has increased.

If you have a time horizon longer than 1 month, this rally is meaningless because the corporate profit cycle is rolling over which will eventually cause the market to correct. If you are worried about the recent rally, don't be. The rally has been propped up by buybacks which are unsustainable. Companies cannot borrow money to buy back stock forever.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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