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Beware, Bulls: Stock Buyback Juice May Dry up if Rates Rise

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December 30, 2014
Beware, Bulls: Stock Buyback Juice May Dry up if Rates Rise

The U.S. market extended its record run in 2014, thanks in part to a prime source of fuel for the bull’s belly over recent years: corporate stock buybacks.

However, traders would be wise to consider how the prospect for higher interest rates in 2015 may alter this dynamic. One reason corporations have been gorging on their own stock is because historically low rates have allowed them to borrow cheaply and funnel that money toward share purchases.

The Federal Reserve, sometime in 2015, is widely expected to hike benchmark rates for the first time since 2006. The onset of a central bank tightening cycle is likely to reverberate across the global financial system in many ways, potentially triggering a U.S. market downswing, if history is any guide.

One simple way to keep an eye on buyback trends is by following an index, the NASDAQ US Buyback Achievers™ Index (DRB). The DRB’s outperformance compared to the Standard & Poor’s 500 index (SPX) since 2012 is notable (see figure 1).

The NASDAQ buyback index is comprised of U.S. securities issued by corporations that have “effected a net reduction in shares outstanding of 5% or more in the trailing 12 months,” according to NASDAQ OMX.

The rationale behind buybacks, when a company goes to the market and repurchases its own shares, comes down to simple supply and demand. If there are fewer shares available for trading and investor demand holds steady or increases, chances are the stock price will climb. Share repurchases are often portrayed as a “vote of confidence” in the company’s financial outlook or an indication management thinks the stock is undervalued.

But if the gap DRB has over the SPX starts to narrow, that may signal that buyback juice is starting to dry up. A likely catalyst for this would be a rise in interest rates. Moreover, a significant period of DRB underperformance might serve as a leading indicator of a bigger stock market correction.

To be sure, as we close out 2014, the trend still appears buyback-friendly for the broader market, and it’s likely to remain that way at least into early 2015. Still. But the relationship between DRB and SPX might be worth watching as the new year unfolds.

FIGURE 1: BUYBACK POWER.

A NASDAQ index (green line) linked to U.S. companies that have repurchased their own shares has increasingly outpaced the S&P 500 (purple) over the past three years. Source: TD Ameritrade. For illustrative purposes only.    

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