5 August 2021


By Raul Elizalde

This article also appeared on forbes.com

An important measure for the value of stocks is the amount of earnings attributed to each share, or EPS. The higher it is, the better, but higher EPS could come from larger total earnings or from fewer shares into which they are divvied up. A decreasing number of shares was one of the most powerful engines of the stock market in the past several years, as shares outstanding kept falling because of corporate buybacks and mergers and acquisitions. But recently, this activity has dried up. Percentage of companies reducing outstanding shares by more than 4%

source: Path Financial LLC, Standard and Poors
In the third quarter of 2020, for example, the total value of equity issued by U.S. companies exceeded the retired amount for the first time in more than 10 years. This was not due to a jump in sales, despite a number of high-profile IPOs (Initial Public Offerings, or sales of new shares by companies going public for the first time). Net issuance jumped because of a sharp decline in equity retirements.

source: Path Financial LLC, U.S. Federal Reserve
If the buyback fuel has gone missing, what is then driving prices higher? Extraordinary liquidity driven by ultra-easy monetary policy is one reason. A mountain of Fed-created cash went looking for a home and found it in the stock market, since rock-bottom interest rates made bonds unappealing.

But there is a more fundamental driver: According to data compiled by Standard And Poors, the number of earnings “beats” (financial results beating the expectations of analysts) has climbed to the highest level since S&P started tracking beats in 2012. Research company Factset confirms it, saying that at 88% so far, the percentage of companies beating expectations for 2Q21 is the highest since they started tracking beats in 2008. And this is not an aberration brought by pre-vs-post pandemic comparisons. Earnings beats have been climbing for many quarters, and they are taking the place of the vanished corporate buybacks in supporting higher equity prices.

source: Path Financial LLC, Standard and Poors
This is good news with an asterisk. It is certainly better to have stocks going up because corporate results exceed expectations than because corporate treasurers keep buying them back. But the vacuum left by the decline in equity retirements means that the two remaining pillars of the bull market are a constant outstripping of earnings expectations and a continued support from monetary policy.

This is going to be tough. For corporate earnings to keep beating forecasts, the economy will have to run stronger than expected. But if that is the case, monetary policy support would no longer be needed. Conversely, if the Fed has to keep injecting money because the economy stays soft, it would imply that corporate earnings would have to soften as well.

There is one way out of this contradiction. The elusive infrastructure bill could pass the baton from monetary policy to fiscal policy, allowing the Fed to start winding down its liquidity-pushing efforts. A further allure of the infrastructure bill is that, properly crafted, it can improve the economy’s productivity. This is the key for improving long-term economic performance and corporate results, as we have argued many times. And this is why the success or failure of this bill may well be the catalyst for the next big equity market move, up or down.

Questions? Talk to us.