Stock Market Rally the Biggest Case of “Financial Engineering” in History?

Source: Market Oracle

Michael Lombardi writes: Key stock indices are roaring higher each day. The S&P 500 is breaking through to new records; the Dow Jones Industrial Average sits above the 16,000 level, and the NASDAQ Composite Index trades at a level not seen since the Tech Boom. Sadly, as all of this happens, the one fundamental that has historically driven stock prices higher—corporate earnings—is missing from the equation.

In these pages, I have often harped on about how companies in key stock indices are buying back their shares at a record pace. I consider this “financial engineering,” because at the very core, what a stock buyback does is make corporate earnings per share look better.

This week, my research team took a look at the Dow Jones Industrial Average companies and how many were buying back their shares. Their findings reveal 28 out of the 30 companies on the index bought back shares over the past 12 months.

From the third quarter of 2012 to the third quarter of 2013, Dow Jones Industrial Average companies collectively bought an outstanding 2.33 billion of their own shares. Effectively, they removed over two billion shares from the market!
What did these stock buybacks do to the companies’ corporate earnings?

Because of the stock buybacks, 70% of all the companies in the Dow Jones Industrial Average were able to show better per-share corporate earnings. For example, for the third quarter of this year, AT&T Inc. (NYSE/T) reported a net income of $0.72 per share, an improvement of 14.3% from the same quarter in 2012. But if AT&T didn’t reduce its share count during that period via its stock buyback program, corporate earnings per share would have been $0.66 in the third quarter of 2013, only 4.7% higher than last year. (Source: AT&T Inc. web site, last accessed November 26, 2013.)

AT&T is just one example where “financial engineering” to prop up per-share corporate earnings has been successful. There are may other cases.

But the trick of buying back stock to push per-share corporate earnings higher is running out of steam. (After all, how much stock can a company buy back before there is no stock left?) Going forward, the stage for key stock indices doesn’t look very stable. As of November 22, 89 companies on the S&P 500 have issued negative guidance about their corporate earnings for the fourth quarter. Meanwhile, only 12 have issued positive guidance. (Source: FactSet, November 22, 2013.)

If there is even a single investor out there who believes the fundamentals are no longer important—that corporate earnings growth isn’t needed for the stock market to rise—they are fooling themselves. At this point, the house of cards can fall at any time.

This article Biggest Case of “Financial Engineering” in History? is originally published at Profitconfidential
Michael Lombardi, MBA for Profit Confidential