A Major Support For Asset Prices Has Reversed

In 2019, we wrote about how corporate share repurchases, or “stock buybacks,” had accounted for nearly all buying in the market. A year later, that significant support for asset prices has reversed.

While markets have certainly been on a tear this year, due to massive amounts of Federal Stimulus, it has been an advance solely on valuation expansion. While the decline in 2020 earnings was no surprise given the pandemic, earnings were already declining in 2019. The chart shows this in the return attribution of the S&P 500.

Asset Prices, A Major Support For Asset Prices Has Reversed

Notably, while investors are willing to “pay more for less” in earnings, revenue growth deteriorated more.


Overpaying For Earnings

Such is not a new phenomenon. Since 2009, sales per share, what happens at the top of the income statement, has cumulatively grown by just 43% through Q3-2020. It is hard to justify bidding up stocks by 400% based on meager revenue growth. So, Wall Street created metrics like “Operating Earnings” to provide justification. The problem with “Operating Earnings” is they are heavily “fudged” to create a more optimistic picture.

Asset Prices, A Major Support For Asset Prices Has Reversed

What do I mean by “fudged?” 

“The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day. Or, recognizing revenues before sales are made. A good quarter is often the time to hide a big “restructuring charge” that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs’ belief these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.

Asset Prices, A Major Support For Asset Prices Has Reversed

The reason companies do this is simple: stock-based compensation. Today, more than ever, corporate executives have a large percentage of their compensation tied to stock performance. A “miss” of Wall Street expectations can lead to a large penalty in the companies stock price.

In a survey conducted with corporate executives, 93% of the respondents pointed to “influence on stock price” and “outside pressure” as the reason for manipulating earnings figures.

A Buyback Boost

The use of stock buybacks has continued to rise in recent years and went off the charts following tax cuts in 2017. As I wrote in early 2018. most thought tax cuts would lead to rising capital investment, higher wages, and economic growth. However, it went where we expected it would. To wit:

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