Second, the primary use of stock buybacks has been to manipulate profitability perception. Companies reduce the number of outstanding shares in existence such that less supply of shares are available, even when demand is flat or waning; effectively, prices have a floor underneath them. What’s more, when there are less shares in existence, corporations appear more profitable than they really are.
Now let us go back to the earlier reality that, earnings-per-share (EPS) are still expected to decline in Q2. So even with record levels of share buybacks, profitability per share will not rise. Nor will revenue. In fact, sales have been flat for years at many of the big-time Dow components and most in the media fail to highlight revenue shortfalls.
There are a few ways in which an investor might attempt to circumvent the artificial earnings dilemma. One possibility is to rely on revenue generating firms, since sales-per-share is more difficult to manufacture than earnings-per-share. The RevenueShares Large Cap Fund (RWL) weights each component of the S&P 500 by revenue rather than market capitalization. The RWL:S&P 500 price ratio below demonstrates that there may be value in overweighting top-line sales winners.
One should recognize that outperformance in a bull market is less critical to long-term investing success than losing less in a bear market. Owning RWL won’t be of much service if the “fit hits the shan.” In other words, in an overvalued stock bull where there is high probability of a severe selloff in the not-so-distant future, one might wish to increase his/her allocation to assets on the lowest end of the risk spectrum. Consider employing iShares 1-3 Credit (CSJ), SPDR Short-Term Muni (SHM) and/or your money market account.
Nobody knows when the global investing community will wake up. I certainly cannot predict when fundamental valuation will matter again, or when economic weakness will create a panicky rush for the exit doors. What I do know is that fear of missing out eventually gives way to fear of loss.
The typical U.S. stock bear will destroy 30% of capital that is allocated to the asset class. That is the history of the financial markets. Those who don’t recognize 150 years of equity market activity are doomed to experience similar price depreciation. Raising cash when the prices are higher and buying when the prices are lower may be one’s best defense.