Who's Actually Buying This Rally?

Stocks have been historically expensive for years. That’s certainly not breaking news, but it’s worth revisiting. The price/sales ratio of the S&P 500 is the highest it’s ever been in history.

Higher than during the Covid FOMO rally… higher than that during the 1990s tech bubble. Literally the highest its ever been in the multi-century history of the U.S. stock market.

Source: https://dqydj.com/sp-500-ps-ratio/

And not just a little more expensive, mind you. Current estimates put the number between 3.3 and 3.6 times sales. At the peak of the dot-com bubble in 2000, the ratio barely cracked 2.0.

The numbers aren’t quite as extreme for the price/earnings ratio, but they’re close enough. Most estimates put the S&P 500 P/E ratio around 26-30. At the peak of the dot-com bubble, the ratio was around 34.

The Shiller P/E, also known as the cyclically-adjusted price/earnings ratio (CAPE)?

At 40.4, it’s closing in on the all-time high of 43 set back in 2000.

The “Buffett Indicator,” Tobin’s Q, the forward P/E…

Pick literally any common valuation metric and they’ll tell you the same thing. This market is historically expensive.

Yes, the AI revolution is real. And yes, it’s making an ungodly amount of money for the companies selling and building out the infrastructure.

But then, the war in Iran and the ongoing energy crisis is also very real, as is the ballooning national debt, the security risks posed by quantum computing, and the fact that most Americans are living hand to mouth after five years of brutal inflation.

So…

Back to the question I asked in the headline: Who’s buying this rally, continuing to bid prices up?

It appears it’s the companies themselves. Through the end of April, Corporate America had announced plans for $665 billion in new buybacks this year. They’re on pace to top $1.55 trillion by the end of the year, setting a new record.

Apple (AAPL) alone has pledged to buy back $100 billion of its own stock. Even just a couple years ago, $100 billion would have represented the entire market cap of a major American company. Today, that’s just the value of the shares Apple plans to buy and retire.

Here’s Where it Gets Weird

But here’s where it gets weird…

The “usual suspects” aren’t the ones buying. Per Bloomberg,

While tech and communication services represent more than 45% of the S&P 500 by market cap, they were responsible for only 38% of share repurchases, based on the latest completed execution data as of late December. In the meantime, cyclical stocks in the energy, financials, industrials and materials sectors accounted for 44% of the dollar value of buybacks, despite making up only about a quarter of the index.

Tech stocks have been juicing their earnings with buybacks for decades. And it made sense… they were cash cows that generated far more cash flow than they needed to fund growth projects.

That’s different today. All of the major players in tech (minus Apple) are plowing every spare dollar they have into AI infrastructure. So the center of buyback activity has shifted to the Old Economy.

Why Does This Matter?

Buybacks are one of those topics that tends to ruffle feathers. On paper, they look great! Like dividends, they give companies a way to reward their long-term owners. But they’re vastly more tax efficient than dividends. Qualified dividends are generally taxed at 15-20% for the investor.

Buybacks generate zero taxes for the investor (unless they sell their shares, in which case they’d owe capital gains taxes). Corporations pay a nominal 1% excise tax on their buybacks.

Buybacks also give companies flexibility. They can turn them on or off as cash flows allow without upsetting their investors, whereas cutting dividends tends to be jarring for the “widows and orphans” who depended on the quarterly checks.

So… what’s the problem with Corporate America going in big with buybacks?

It turns out their timing is terrible. Companies tend to buy their shares when they are expensive… and then sell them (or seek other financing) when they are cheap. And the buybacks often come at the expense of needed investment and leave the companies dangerously exposed.

Throwing out a few examples…

Between 2013 and 2019, Boeing spent $43 billion on buybacks — 104% of its profits over that period — rather than addressing design flaws in its jet models. That went about as well as you might expect.

Those buybacks drove Boeing’s net equity negative — the share repurchases had literally destroyed the equity on its balance sheet. When the 737 MAX crisis hit and COVID followed, Boeing had to scramble to borrow $10 billion or more just to stay liquid, money that had already been handed to shareholders at elevated prices.

Boeing’s customers were serial offenders too…

The big four U.S. airlines — Delta, United, American, and Southwest — spent a combined $43.7 billion on share buybacks between 2012 and 2019, then turned around and sought a $50 billion federal bailout when COVID hit, having left themselves with minimal cash cushion. They bought their own shares at elevated prices throughout the long bull market, then needed taxpayer money to survive the first serious downturn.

Perhaps the worst case was General Electric. General Electric is a shell of what it once was due in no small part to excessive buybacks.

In the ten years leading up to 2017, GE spent $53.9 billion to repurchase 2.07 billion shares at an average price of $26. By mid-2019, GE’s stock had fallen to $8.38 — meaning the company could have bought back those same shares for roughly $17.4 billion, one-third the cost. Investigative accountant Albert Meyer called it “destruction of capital”: $36.5 billion in shareholder wealth vaporized, a sum equivalent to half of GE’s entire market capitalization at the time.

The worst single year was 2016. Under CEO Jeff Immelt, GE spent $21.4 billion repurchasing shares at an average price of $30.30 — more than double what they’d trade for just two years later.

Much of the capital for these buybacks came not from operating earnings but from asset sales — most notably the $20.4 billion Synchrony Financial spin-off in 2015. GE essentially liquidated parts of its franchise to buy back stock at peak prices, then made two enormous industrial acquisitions — Alstom in 2015 and Baker Hughes in 2017 — that proved poorly timed as energy markets deteriorated. By late 2017, the bill came due: GE slashed its dividend by 50% and began the long dismemberment that would eventually end with the conglomerate splitting into three separate companies by 2024.

Now What?

Excessive buybacks don’t necessarily mean that a market top is imminent. But it does raise questions about the quality of the buying. At the first hint of a slowdown, buybacks tend to dry up.

I’m not recommending you sell everything and hide under a rock. It’s far too early for that.

But you should be careful. Make sure you’re regularly rebalancing your portfolio to trim back appreciated stock. And if your “normal” portfolio allocation is something in the ballpark of a 70/30 stock/bond portfolio, consider dialing back the risk a little to 60/40 or 50/50 (or whatever the equivalent would be for you given your current allocation).

We’re in the late stages of a bubble. There’s still potentially a lot of money to be made, and we want to participate in that, but we do not want to be betting the farm here.

So, again…

Stay invested. But check your overall risk level and be sure that you’re regularly rebalancing.

If that’s something you’d like a little help with, please contact my office. That’s something I do for prospective clients free of charge.

Charles Lewis Sizemore, CFA