Much has been said lately about the popularity of company share buybacks which accelerated greatly in 2013. All of these activities are completely legit of course, yet I want to deconstruct how these buybacks have greatly contributed to this entire bull market being a complete unsustainable sucker’s game. A game that is based on a gigantic lie, a well packed & well marketed lie, but a lie nonetheless. And Wall Street, its analysts, corporate management, the media, and gullible/complacent/misinformed investors are all doing their part in keeping the big lie afloat. The big lie: Accelerating earnings growth.

A brief summary of the facts: in 2013 over $448 billion in share buybacks have been authorized by S&P 500 company boards running at a clip of over $120 billion per quarter with key companies reducing their float by 3%-10%. These buybacks, more often than not, are financed through the taking on of new debt made feasible via low interest rates courtesy of your forever friendly Federal Reserve.

How The Giant Sucker’s Game Works

I’ve created a hypothetical company X to walk you through a simplified, even conservative example of how these buybacks are creating a complete alternate reality which distorts expectations, valuations and is entirely misleading investors.

Let’s starts with the base case. Company X is chugging along at 3% organic earnings growth. The company has a float of 100M shares and I’ll even assume the market is pleased with the earnings growth and rewards the company with some P/E expansion as markets are generally bullish. Great! Market cap is increasing at over 6% a year, the company is earning money, shareholders get rewarded. All is well.

But wait, we can create magic and make our shareholders rich, because investors will eat up what we are selling. Rates are cheap so we borrow money and reduce our float by joining investors in the marketplace and buying our own shares. We do this by adding some cheap debt to the balance sheet. As interest rates are low the impact on our P&L in terms of interest expense is immaterial. Indeed it will make us look fantastic as our reduced float will create the illusion that our organic earnings growth is much higher as the same earnings are divided over fewer remaining shares. And now our earning growth is in the 6% + range as opposed to 3%. But that’s not all, now the real magic begins!

Now we get upgrades from the same banks that advised us on these buybacks in the first place and the higher earnings growth numbers will get us higher price targets and investors are getting exited about the growth story narrative and are buying more shares driving up the price even higher. And of course we help create more buying pressure with our share buyback program. In fact we support our share price so investors don’t really have to worry about our stock correcting. The result: P/E multiple expansion and our investors are rewarded with a much higher market cap, our management is making millions in bonuses, and all is wonderful.

Just one problem. Well three major ones actually:

1. No increase in organic earnings is necessary to create higher market cap. Investors are paying a higher price for shares that have no higher underlying intrinsic value. That is the classic inflationary sucker’s game based on nothing but financial engineering.

2. As share values increase companies, by definition, are paying higher and higher prices to buy back their own shares. As a sizable, incremental buyer in the market they have to keep staying in the game to keep the story afloat making it more and more financially prohibitive to continue ad infinitum.

3. Buybacks are now a substantial part of the future earnings growth story. Do buybacks last forever? Of course not. As the chart at the top of this article shows buybacks were a driving part of the bull market leading up to 2007/08 when they suddenly stopped. And stop they will at some point, either forced via higher rates or ever expanding P/E’s will force the issue.

Should a company buy back its own shares with a P/E at 50 for example? Well if the organic earnings story supports it maybe. But as we know organic earnings growth has actually been regressive. In fact, free cash flow for companies declined 5.5% in Q3 of 2013 and earnings expectations continue to be reduced across the board. So we’ve been observing an environment where companies have increased their buybacks while their operating performance has been decreasing. Not sustainable. The ultimate conclusion: Companies will reduce their buybacks or ultimately pause or stop them altogether. The result: Without a correlated substantial increase in organic earnings growth companies will be faced with regressive earnings growth even if organic earnings growth remains flat at 3% as in my company X example. Remember the jump to 6% + earnings growth? Just to maintain flat earnings growth comparisons company X would have to DOUBLE their organic earnings growth. Best of luck. So the result? P/E contraction and market cap reduction, in short: a major corrective process that realigns valuations back with fundamentals.

Concluding, a quick look at the market cap expansion comparison highlights how significant value can be created out of nothing as my example of company X assumes the exact same organic earnings results, yet creates a run away bull market for its shares that ultimately produce nothing, except value for the few.

Investors will ultimately get hurt no doubt, but no worry, management, banks, shareholders will have long reaped the benefits while employees will go throughout the next round of layoffs as earnings growth will have to be at least maintained as best as possible. And what better way than through operational efficiency. And yes these coming layoffs and reduced benefits will result in the next rounds of QE as the coming recession has to be prevented at all costs.

And so the cycle can repeat itself. While all this benefits the few, a map of the ever expanding poverty levels across America makes it clear who this mirage is not helping: The American society at large.

So watch out for reduced buybacks and increased insider selling. Market conditions will change rapidly and those with a trade process can generate some very nice profits along the way. For more on how to join us please check the sign-up page.