Here’s the Real Reason Stocks Are Rallying

Casey Daily Dispatch
via Casey Research

By Justin Spittler
Delray Beach, Florida
July 26, 2016

It's hard to ignore the current rally in U.S. stocks. Last week, the S&P 500 and Dow both hit record highs. The S&P 500 has now climbed four weeks in a row, up 8% since late June. Some folks might see this and think now is a good time to get back into stocks. But if you've been reading the Dispatch, you know these headline numbers aren't telling the whole story.

You see, the stock market is actually a very dangerous place right now. Today, we'll show you why, and we'll tell you how you can protect your wealth while giving yourself a chance to profit when the market heads lower. But, first, let’s look at how U.S. companies are really doing. 

Second quarter earnings season is in full swing 

Earnings season is when companies let the world know how business is going. Management tells investors if profits grew or shrank during the last quarter. Many companies also give an outlook on next quarter’s results. A good earnings season can send stocks higher. A bad one can trigger a selloff.

According to research firm FactSet, 25% of the companies in the S&P 500 shared second-quarter results as of Friday. Based on these numbers, the S&P 500 is on track to post a 3.7% decline in earnings. This would mark the fifth straight quarter of falling earnings. And that would match the longest earnings drought since the 2008–2009 financial crisis.

It could be a while before earnings pick back up

Analysts expect the S&P 500 to post a 0.1% decline in third-quarter earnings. The third quarter ends on August 31. According to FactSet, Wall Street projected third-quarter earnings to rise 3.3% as recently as March 31. In other words, corporate profit expectations are rapidly deteriorating. At this point, you’re probably wondering why stocks are rallying. After all, one of the main reasons folks buy stocks is to earn a share of future profits. Shrinking profits should cause stock prices to fall.

Companies are buying near record amounts of their own shares

The Wall Street Journal reported two weeks ago: Companies in the S&P 500 bought back $161.39 billion of shares during the first three months of the year, the second-biggest quarter for repurchases ever. A share buyback is when a company buys its own stock from shareholders. Buybacks reduce the number of shares that trade on the market. This boosts a company’s earnings per share, which can lead to a higher stock price. But buybacks do not actually help companies grow profits. They only make profits look bigger “on paper.”

According to The Wall Street Journal, the total number of shares of stock on the market is shrinking for the first time in five years. Shares outstanding in the S&P 500 have fallen this year from year-earlier levels, on track for the first yearly decline since 2011, according to S&P Dow Jones Indices. The huge spike in share buybacks has made corporate earnings look better than they really are, which is troubling given that earnings haven’t grown since 2014.

Companies are buying back their shares at the worst possible time

You see, stock buybacks aren’t necessarily a bad use of money. If a company’s stock is cheap, a share buyback can be a good use of capital. But, as Dispatch readers know, stocks aren’t cheap. According to the popular CAPE ratio, stocks in the S&P 500 are 61% more expensive than their historic average. Since 1881, U.S. stocks have only been more expensive three times: before the Great Depression, during the dot-com bubble, and leading up to the 2008 financial crisis.

The more earnings fall, the more expensive stocks become

The CAPE ratio is the conventional price-to-earnings (PE) ratio with one tweak. Instead of using one year's worth of earnings, it uses earnings from the past 10 years. It gives us a long-term view of the market. But like the PE ratio, CAPE can only increase if 1) stocks rise or 2) if earnings fall. Both are happening right now.

That’s a big reason why we’re so skeptical of this rally. You see, stocks could rise another 5% or even 10% over the next few months. But, with earnings in decline, stocks will only get more expensive the higher they climb. Expensive stocks crash faster and harder than cheap stocks. In short, you’re risking a lot of money for the chance to make a little if you own the S&P 500 right now.