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How to Profit from Buybacks

Written by Briton Ryle
Posted March 21, 2016

Over the last five or six years, U.S. corporations have provided one of the most significant upside catalysts for stock prices. No, I'm not talking about earnings...

Of course, earnings do help: rising corporate earnings have provided a solid foundation for higher stock prices. But that particular catalyst is not really in play right now. Earnings have been declining on a quarterly basis for about a year now. And we have seen the impact of falling earnings on prices, as lower earnings usually translate to lower prices. 

But a funny thing has happened on the way to the bear market for stocks...

Over the last few weeks, stocks have put together an incredibly powerful and impressive rally. So strong, in fact, that 89% of the stocks on the S&P 500 are now trading above their 50-day moving averages.

I'd like to explore in a little more detail why this has happened, why it's significant, and what we can expect next. Because the simple fact is, despite how good this rally looks, there's a pretty good reason to believe that it will reverse just as individual investors get comfortable with the idea that stock prices are going higher.

What's So Great About the 50-Day MA? 

You'll notice that the S&P 500 stalled briefly at its 50-day moving average (MA), the blue line, and then proceeded to just break above the 200-day MA, the red line. 

SPX 1 year march 2016

The 50-day and the 200-day moving averages are useful and well-recognized support/resistance points. So it makes perfect sense that stock prices gravitate to them. But what do these moving averages actually mean? 

Glad you asked...

In a very general way, you can think of the 50-day moving average as a swing trading indicator and the 200-day moving average as a trend indicator. Let me show you what I mean by that.

The following chart is a three-year chart of the S&P 500. Again here, the blue line is the 50-day moving average and the red line represents the 200-day moving average. 

spx 3 year march 2016

There are a few things to note about this chart. The most basic is the direction of both moving averages. When they are moving up, it's because stock prices have been moving up. When they are moving down, it's because stock prices have been moving down.

This is an especially important point when it comes to the 200-day moving average. The 200-day MA is a long-term average, covering the last 200 days. So it doesn't change quickly or easily. It takes sustained weakness (or strength) in price for it to change directions. That's why it's a trend indicator. 

On this chart, you can see that the S&P 500 basically stopped moving higher in early 2015 (a year ago). That allowed the 200-day MA to “catch up” to prices (because prices weren't moving higher anymore). 

Lower prices started on the S&P 500 in July 2015. Let's remember that was the last time the Greek bailouts were making headlines, and global debt issues were creeping into investors' consciousness. 

Then in August, China surprised the markets and devalued the yuan, and that got the whole bear market talk started in earnest. It is not a coincidence that the S&P 500 dropped below the 200-day MA at that time. Investor fears hit stock prices, and you can see the result on the charts...

Bull Market Return? 

So right now, the S&P 500 is breaking above its 200-day MA, suggesting that maybe the long-term trend has changed back to the upside and that the bull market is back. Is that a signal we can trust?

Well, it's never a good idea to rely on just one signal to make investing decisions. As we've noted before, stock prices rise and fall for a wide variety of reasons. And one big reason stocks have been rising might be about to take a little break...

So far this year, the companies of the S&P 500 have been buying back their stock at a near record pace. Yeah, I was surprised too, given that growth around the world has continued to slow and interest rates have been moving higher. 

But according to Bloomberg, S&P 500 companies are on pace to buy back $165 billion in stock during the first quarter (January–March 2016). That would be right around the record for the most stock purchased in a quarter since 2007...

So if you're looking for who's been buying stock and why prices have been rising, well, it's the companies themselves. Individual investors have actually pulled a net $50 billion out of equity funds so far this year. 

The chief U.S. equity strategist at Goldman Sachs, David Kostin, told Bloomberg: “Corporate buybacks are the sole demand for corporate equities in this market...” 

That doesn't exactly fill me with confidence that the bull market is indeed back.

Musical Chairs: When the Buybacks Stops 

Since 2009, S&P 500 companies have spent over $2 trillion buying back their own stock. And the S&P 500 itself has tripled in that time. 

Of course, we can't expect these companies to continue to be the biggest buyers in the stock market. At some point, regular investors will have to step in and take up some of the slack. 

And we may be about to see if that can actually happen...

Buried deep in that Bloomberg article I mentioned earlier was this little nugget, also from David Kostin: 

Kostin said companies tend to enact a blackout period and restrict share repurchases in the month following the end of a calendar quarter, and come back once they’ve reported results. In a market where everyone else is selling, the ebb and flow of corporate actions have amplified volatility.

Companies tend to stop buying their own stock in the months before they report earnings and start buying stock right after they report. 

It's no coincidence that the S&P 500 was pretty weak right before earnings season started in late January. And within three weeks, after the majority of S&P 500 companies reported, stock prices started moving higher.

But guess what? Earnings season gets underway in just a little over a month. And that means over the next week or two, S&P 500 companies will stop buying their own stock, and the most important catalyst for higher prices will be gone. 

Will individual investors step in and pour $50 or $60 billion into the stock market over the next few weeks to support prices? Maybe. But I doubt it. So if you're looking to buy stocks, you might want to wait for the second or third week of April, when stock prices will likely be lower than they are today.

Until next time,

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.

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