A 14-year trend that's been driving the stock market takes a sharp turn

One of the biggest drivers of the stock market's historic boom over the past 14 years has been so-called "buybacks." This is where a company buys back its outstanding shares, pushing up its stock price.

These deals can reach dizzying proportions over time. Apple, for example, has spent a whopping $625 billion buying back its shares over the past decade.

Now, that trend is beginning to slow down.

From an all-time high of $1.3 trillion in total share buybacks last year, the pace has fallen by more than at any time except during the Covid Crisis in 2020 and the Great Recession.

Total S&P 500 second-quarter 2023 buybacks were $174.9 billion, down 18.8% from the first quarter and down 20.4% from the second quarter of last year.

Why this is a really big problem

Buybacks have been the primary driver of stock market returns since 2012.

In fact, as the FT's Robert Armstrong recently noted, "For a long time, corporations have been the only consistent net buyer of US stocks." And that's not some spooky speculation; it's cold, hard data:

If companies back off on share buybacks, that means the main source of funds flowing into stocks will dry up.

Ordinary investors buy and sell stocks as their investment needs change. Individuals, for example, buy stocks during their prime career time as they accumulate capital, then sell in retirement.

Asset managers buy them with money from retirement funds and insurance companies, and sell them when those clients need funds to pay pensions and insurance claims.

Companies, by contrast, just buy back their shares and sit on them.

What caused companies to buy back so many shares?

To understand this, a little history is in order.

Before 1982, buybacks were illegal. The government saw them as a form of share price manipulation. Then deregulation came along, and the government started to allow them… up to a point.

Technically, a company should buy back its shares when their prices are depressed to score a better deal, as in around recessions.

But as the charts above show, they do exactly the opposite.

When stocks were expensive, as in 2006, 2018, and late 2021, companies were buying back shares like there was no tomorrow. During Covid and the Great Recession, on the other hand, buybacks were largely cut dead.

Why? Because management is usually paid (in part) in stock options, it wants to goose the share price by raising earnings per share (EPS).

Think of it this way: If a company has $100 in earnings and 100 shares outstanding, its EPS is $1. If it is in an industry that trades on a multiple of 10 times EPS, its stock price will be $10 per share.

If it buys back half its shares, its EPS doubles to $2, and its stock price rises to $20.

Even worse, for most of the past decade, companies have borrowed at super-low rates to buy back shares.

This diverts capital from useful productive investments and directs it toward making debt payments on faux share purchases, reducing the company's long-term growth prospects.

Buyback advocates say that companies are simply returning cash to investors who, if they hold on to their shares rather than sell them, can postpone paying capital gains taxes. Everybody wins, the theory goes.

Not everyone agrees.

For example, Abrie Pretorius, a manager at Ninety One, said, "Buybacks only create value for remaining shareholders and strong relative performance when shares are cheap and there are no better uses of that cash which would generate higher returns. Most buybacks help optical [earnings per share] growth but destroy value."

Fidelity's UK equity fund manager Leigh Himsworth agrees: "As a shareholder you feel like you never actually get the reward [with buybacks]."

"If the market is nonplussed by it then, as a shareholder, you are worse than square one, as the company has typically used up their cash."

What's causing companies to slow down now?

According to the S&P Global, three things are principally to blame.

First and most obvious, interest rates have been rising at the fastest pace in half a century, so companies naturally can't borrow as much to buy back shares.

Second, the mini banking crisis in the first quarter caused banks to lend less and demand stricter terms on loans, cutting back the flood of cheap debt available to fund buybacks.

Finally, the Biden administration imposed a 1% tax on share buybacks, which came into effect in January.

Most observers believe this had a negligible effect, but because the tax had bipartisan support, it could be increased to the point where it is a real deterrent.

In fact, Biden has floated the idea of quadrupling it.

What will happen if the trend reverses?

It makes sense for some companies to return cash to investors.

None of the top five buyback artists in the second quarter—Apple ($19.9 billion), Alphabet ($15 billion), Microsoft ($5.7 billion), ExxonMobil ($4.3 billion), and Chevron ($4.3 billion)—appear to be cutting back on research or investment to fund their activities.

But smaller companies are.

Eighty-seven percent—434 companies—of the S&P 500 did some buybacks within the 12 months ending June 2023. Some of these companies borrowed to the gills to do so, reducing their ability to grow and increasing their credit risk.

If the Fed doesn't hold back on rates and the economy enters recession, those nimble "financial engineers" may be the first domino to fall in the buyback fallout.