Why the Last Scheme for Propping up Corporate Earnings is Almost Done

The corporate earnings growth of companies in key stock indices for the second quarter has been very weak—and it looks like yesterday the stock market finally started to take note (the Dow Jones Industrial Average was down 225 points yesterday). To boost per-share earnings, companies in key stock indices have resorted to stock buy-back programs, something investors are finally starting to catch onto.

This shouldn’t be a surprise to readers of Profit Confidential, as I have been writing and scrutinizing this phenomenon for some months now.

This is how it works. Say a company called ABC Inc. has 10 million outstanding shares and earns $1.0 million in profit for the year. Its corporate earnings per share would be $0.10.

Now, let’s suppose the company ABC goes out and buys back two million of its own shares in the open market. With everything else remaining constant, its corporate earnings per share will increase to $0.125 per share, a jump of 25%. The company didn’t make more money; it just reduced the number of its outstanding shares, which boosted per-share corporate earnings.

And the companies involved in these stock buy-back programs are big and well-known, listed on key stock indices.

3M Company (NYSE/MMM) reported second-quarter corporate earnings of $1.71 per share—three percent higher than during the same period a year ago. During the same quarter, the company repurchased $1.2 billion worth of its own shares. It doesn’t end there. 3M said it has boosted its stock buy-back program. The company originally said it would buy anywhere between $2.0 billion and $3.0 billion of it shares on the open market. It now plans to buy between $3.5 billion and $4.0 billion worth of its own shares. (Source: 3M Company, July 25, 2013.)

The Home Depot Inc. (NYSE/HD), the world’s largest home improvement retailer, bought $2.1 billion of its own shares and said it plans to buy an additional $4.4 billion worth of its own shares for the rest of its current fiscal year. (Source: Home Depot, May 21, 2013.)

These two companies aren’t the only ones buying back their shares. The list includes big-cap companies on key stock indices, such as International Business Machines Corporation (NYSE/IBM), General Electric Company (NYSE/GE), Pfizer Inc. (NYSE/PFE), and Halliburton Company (NYSE/HAL)…and the list is growing.

The problem with stock buy-back programs is that they can’t go on forever. Either a company runs out of money to buy its stock or reduces the amount of stock in circulation to the point where it starts to hamper liquidity. In other words, the masking of corporate earnings growth cannot go on much longer.

In the first quarter of this year, only half the companies in the S&P 500 met their sales expectations. It will likely be the same once the remainder of the S&P 500 companies finishes reporting their second-quarter corporate earnings.

Yesterday, the stock market finally heeded some of the warning signs I have been writing about for months: slowing corporate earnings and revenue growth; corporate insiders dumping stocks at an alarming pace; bullishness amongst stock advisors at multi-month highs; bond funds buying stocks; margin debt on the NYSE at a record high; and now interest rates rising sharply (you can see all the reasons this market will collapse in my Dire Warning for Stock Market Investors video.)

What He Said:

“For the economy the message from retail stocks is quite clear: Consumer spending, which accounts for roughly 70% of U.S. GDP, is in jeopardy. After having spent like ‘drunkards’ during the real estate boom years, consumer spending is taking the same trend as housing prices, slowing down faster than most analysts and economists had predicted. As news of the recession continues to make headlines in the popular media, the psychological spending mood of consumers will continue to deteriorate, lowering earnings at most high-end retailers, and bringing their stock prices down even further.” Michael Lombardi in Profit Confidential, January 28, 2008. According to the Dow Jones Retail Index, retail stocks fell 39% from January 2008 through November 2008.

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