This Major Market Tailwind Is Hiding a Dirty Secret

Steve's note: This bull market is in its final innings. I hope you're on board for the Melt Up... And I hope you're also preparing for the Melt Down. Read on to learn how a market tailwind that could soon betray investors – and to find out about an event on May 15 that could be a crucial part of preserving your wealth in the coming years.


"This is the longest bull market in history... When will it end?"

It's the question on most investors' minds today.

No one is looking forward to the next bear market. We all remember the last bear market in 2008-2009, when stocks fell almost 60% from their peak.

Now, every little tremor or correction in the market – like the one we experienced in December – reignites that fear.

Today and tomorrow, I want to share some insights into why the bull market has been able to last this long. But more important, I'll share what will ultimately bring it to its end.

Let's start with what has been propelling the market higher for so long...

We all know the Federal Reserve's easy money policies have propped up the stock market since the Great Recession. The Fed slowly lowered interest rates until they were near zero and it couldn't lower them any further.

These artificially low interest rates made fixed-income investments like bonds less attractive and made stocks more attractive. Plus, the Fed's "quantitative easing" program created massive amounts of new money that eventually made its way into the stock market, creating a rising tide that pushed stock prices higher.

But the Fed's monetary policies had another unintended impact on the stock market. It created another strong, but lesser-known, tailwind to the bull market... one that has been blowing especially hard in recent years.

I'm talking about stock buybacks...

Companies have used the Fed's artificially low interest rates to gorge themselves on debt. And many have been using this money to buy back their own stock.

In short, when a company buys shares of its own stock, its stock price usually rises. Most buybacks are done in the open market, just like when individual investors buy shares.

When companies buy back large amounts of their own stock, they bid up prices... pushing their stock prices higher and higher. It's a classic case of supply and demand. Buybacks increase demand for shares, while at the same time reducing the supply of shares available in the market for other investors.

You might not realize how much of a tailwind buybacks have been to this bull market...

In the aggregate, companies buy back billions of dollars' worth of shares every quarter. They are the single largest source of demand for U.S. stocks. By some estimates, the number of shares bought as part of corporate buybacks is more than two times larger than exchange-traded funds (the second-largest source of demand) and six times greater than the number of shares bought by mutual funds.

But it's not just the added demand that pushes stock prices higher...

After a buyback, each remaining share ends up controlling a larger percentage of the company. And in theory, that makes them more valuable. It's like cutting a pizza into six slices instead of eight. The pizza is the same size, but each slice is now bigger. That's why buybacks are considered a return of capital to shareholders, like dividends. It's another way companies reward shareholders.

But the truth is that most buybacks aren't done for the benefit of shareholders. They're done for the benefit of management.

Buybacks are hugely popular among CEOs and CFOs of publicly traded companies for two reasons...

For one, they increase a company's earnings per share ("EPS") without any increases in earnings. By reducing the number of shares outstanding, management can increase EPS without any changes at all to its profits. It's accounting magic.

Let me give you an example... Say a company called Acme Corporation has $2 million in annual earnings and 1 million shares outstanding ($2 in EPS). Acme management buys back 200,000 shares of its stock the following year, so there are now 800,000 shares outstanding. If earnings remain the same, the company's EPS jumps 25% to $2.50 per share without anything else changing ($2 million in earnings divided by 800,000 shares).

This is important because EPS is one of Wall Street's favorite financial metrics. Companies are often rewarded with higher stock prices when their per-share earnings jump. Buybacks make meeting – and beating – Wall Street's estimates much easier.

That leads to the second reason executives love share buybacks: A huge part of their compensation is tied to their companies' stock prices.

Let's look again at our hypothetical example with Acme and assume the stock market valued the company's equity – or its market cap – at $50 million before the buybacks. That means each share would be worth $50 ($50 million market cap divided by 1 million shares). Its price-to-earnings ratio would be 25 before the buybacks ($50 share price divided by its $2 EPS).

After buying back its shares – assuming the stock market continued to value the company at the same $50 million valuation – each share would now be worth $62.50 ($50 million divided by 800,000 shares outstanding after the buybacks). That's a 25% increase in the stock price. The company's price-to-earnings ratio would remain the same at 25 ($62.50 share price divided by its $2.50 EPS) in this example, so the stock wouldn't look any more expensive.

Top executives earn millions of dollars with bonuses and stock options tied to EPS and share prices. In other words, they have plenty of incentives to buy back their shares quarter after quarter.

By now, you can see why management loves buybacks. Increasing a company's EPS and share price without having to increase profits sounds pretty good, right?

Don't get me wrong... Under certain circumstances, buybacks can be a good thing. But like any good thing, they can be abused if taken to excess. Far too often, they're nothing more than nifty financial engineering.

Tomorrow, I'll show you some of the worst offenders that could be sitting in your portfolio right now. And I'll explain how the glut of buybacks we're seeing now could ultimately spell doom for this historic bull market...

Good investing,

Mike DiBiase

Editor's note: This bull market isn't over yet... But we are getting to the final innings. You need to prepare for what comes next. On Wednesday, May 15 at 8 p.m. Eastern time, Porter and investing legend Jim Rogers will sit down to discuss how you can protect and grow your wealth when the wind changes. You can tune in online at no cost – just click here to reserve your spot.

Further Reading

"Most folks are confused," Ben Morris writes. "The market has taken a wild ride since this time last year... But confused doesn't have to mean paralyzed." Read more about one of Ben's strategies for an uncertain market here: Are You Bullish, Bearish, or Confused?

"I'm not saying a market crash or recession is coming today or tomorrow," Dr. David Eifrig says. "But I'm seeing signs that the economy is reaching its high-water mark." Get the details on his plan to prepare for a market downturn right here.

Market Notes
IT MAY NOT BE FLASHY, BUT IT WORKS...

Today, we’re revisiting a thriving “boring” business…

All your friends probably talk about trendy IPOs like Lyft (LYFT) and Pinterest (PINS). But you can find much safer investments out there. These “boring” businesses are easy to overlook… but they’re usually far more profitable over time. Today’s company is a perfect example…

We’re talking about Cintas (CTAS). The $23 billion company specializes in uniforms like work shirts and cold-weather outerwear. Cintas’ trademark is helping its customers get “Ready for the Workday.” And it works with more than 1 million businesses across North America. The uniform business may not be thrilling, but it sells… In the latest quarter, Cintas reported total revenue of $1.7 billion, roughly 6% higher than the same quarter in 2018. And sales have risen every year for the past five years.

As you can see in today’s chart, CTAS shares are in a strong uptrend. The stock has more than tripled over the past five years, and it recently hit a fresh all-time high. It’s more proof of why you want to own “boring” businesses…