Goldman Sachs is calling for a major recovery in stocks.
It’s reasoning isn’t something you should be banking on though.
In fact, it’s something I actively recommend betting against.
Short-Term Gain, Long-Term Pain
Goldman’s forecast for a stock market recovery are based on a surge of stock buybacks.
According to Fox Business, Goldman said:
[Stock] buybacks represent a tailwind to share prices and a reassuring sign that a volatile market is not hampering corporate spending.
In each year since 2010, corporate demand via buybacks and M&A has represented the largest source of inflow to the U.S. equity market.
We expect this pattern will repeat in 2016.
Sounds pretty good right?
If history is our guide, stock buybacks should provide hundreds of billions of fresh cash into the markets.
However, if you’ve been reading along the past few months, you know the theory doesn’t match with reality.
Let me explain.
As you know, share buybacks are when a company takes it’s free cash flows -- usually generated from earnings or borrowing money -- and buying its own shares out of the market and retiring them.
For companies, it’s a low-risk way to grow earnings per share.
After all, if total earnings are the same, you just have to buy out 10% of shares outstanding and, voila, the all-important earnings per share would jump 10% too.
It doesn’t seem too bad. But in reality, over time it certainly isn’t good.
This theory presented by Goldman has two major issues with it.
The first issue is that stock buybacks are nothing more than financial engineering.
And financial engineering tends to lead to short-term gains and long-term pain.
Just look at what happened over the past couple of years.
Some of the world’s largest companies have literally squandered tens of billions of dollars on share buybacks.
IBM (IBM) has been one of the stock buyback leaders. It, however, bought big and bought high.
While it was buying back tens of billions dollars worth of its own shares, IBM failed to deliver any fundamental business growth and IBM share prices dropped heavily from their artificial highs.
As a result, IBM is now down well into eight figures on its stock buybacks.
Caterpillar (CAT) is another example. It was buying big when it’s stock is high. Then the mining and commodity downturns caused revenues and earnings to drop and brought Caterpillar shares down with them.
Today, Caterpillar shares are down 30% in the last year and all those billions of dollars it spent on share buybacks has evaporated.
There are countless more examples and they all point to one thing - share buybacks over have become basically a lose/lose situation.
That’s where the second issue with Goldman’s expectations come in.
The investment banking giant predicts a record year for stock buybacks in 2016.
There’s a very real risk of buybacks not setting a new record. Probably not even anything close.
This chart we featured a few months ago of historical buyback levels for the S&P 500 companies shows why:
The total numbers for 2015 still aren’t in (we won’t know until all S&P 500 companies have reported last quarter’s earnings), but we can see that stock buybacks have already been at or near historic high levels.
Goldman expects them to go higher. Really? That’s not a bet I’d make and you shouldn’t either.
Companies need cash to buy back their own shares. Where’s that cash going to come from?
In the last four quarters revenues have declined for S&P 500 companies as a whole. No money there.
In the last three quarters earnings have declined for S&P 500 companies as a whole. No money there.
Wait, maybe they’ll just borrow more money and buy back more shares.
They could, but we know how that ends. Look back at IBM and Caterpillar to see how borrowing money to buy back shares works out.
This is all why we’re not expecting stock buybacks to “rescue” stocks this year.
The theory’s nice and all, but history just doesn’t prove the theory.