What Is Keeping The S&P 500 Artificially High?

In the first quarter of 2013, companies on the S&P 500 repurchased $97.8 billion worth of their own shares.

That represents an increase of 4.3% from the previous quarter (fourth quarter of 2012), and a 17.2% hike from the same period a year ago. Over the trailing 12 months, the S&P 500 companies have repurchased almost $400 billion worth of their own shares. (Source: FactSet, June 27, 2013.)

Some of the big-cap companies on the S&P 500 are buying back a significant number of shares. Consider Oracle Corporation (ORCL), for example. The software giant on the S&P 500 has repurchased $10.65 billion worth of shares in the trailing 12-month period. That amount is the sixth-highest among the S&P 500 companies.

Other companies are doing it, too. AT&T Inc. (T), a big-cap telecommunication company on the S&P 500, has repurchased its own shares amounting to $5.9 billion in the first quarter.

Big-cap companies that have been on the index since the fourth quarter of 2004 have been reducing their number of shares outstanding for seven straight quarters. In the first quarter, their shares outstanding declined 1.1% year-over-year.

This shouldn’t be surprising to my Profit Confidential readers; I have been talking about this issue in these pages for some time. By reducing the number of shares a company has outstanding, corporate earnings per share automatically increase.

For example, say a company has 10,000 shares outstanding and has corporate earnings of $100.00, or $0.01 per share. If the company buys back 2,000 shares and its profits remain at $100.00, per-share earnings will rise 25% to $0.0125. This is nothing but financial engineering, and investors should be careful about its effects on corporate earnings.

In hindsight, as the key stock indices like the S&P 500 continue to rally, corporate earnings estimates for the second quarter are sliding lower.

At the end of March, analysts expected corporate earnings growth for the S&P 500 companies to be 4.2%. For the week ended June 28, the corporate earnings growth rate for the S&P 500 companies declined to 0.8%. (Source: FactSet, June 28, 2013.)

Here’s what I am also watching: cash and short-term investment accounts on the financial statement of the S&P 500 companies increased by $30.1 billion in the first quarter, amassing to $1.29 trillion. The first quarter of this year was the fourth in a row in which the S&P 500 companies increased their cash positions. (Source: FactSet, June 27, 2013.)

Combining these two phenomena—the S&P 500 companies buying back their own shares and increasing cash on their balance sheets—I see two implications.

First, those companies might repurchase more shares and make investors believe their corporate earnings are actually better than they appear.

And second, it shows me that companies on the key stock indices are not spending. They are not investing in projects that create jobs and eventually drive the U.S. economy toward economic growth. The struggles in the jobs market we have seen since the financial crisis might just continue.

While companies are artificially pumping up their stock prices, it might be prudent to avoid the S&P 500 until things settle down and stock prices are more in line with valuations.

Disclaimer: There is no magic formula to getting rich. Success in investment vehicles with the best prospects for price appreciation can only be achieved through proper and rigorous research and analysis. The opinions in this e-newsletter are just that, opinions of the authors. Information contained herein, while believed to be correct, is not guaranteed as accurate. Warning: Investing often involves high risks and you can lose a lot of money. Please do not invest with money you cannot afford to lose.

Original post