This Leading Indicator Suggests the Stock Market May Be on the Precipice of Tumbling

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The stock market has had a wild year. It began with the worst two-week start in recorded history, with all three major U.S. indexes losing between 8% and 10% of their value. This was followed by hitting even lower lows by mid-February, firmly putting U.S. stocks in correction territory. After this drop, the market rallied voraciously, with the S&P 500 staging the biggest intra-quarter comeback in 83 years, to end Q1 in the black. This has not been a market for the faint of heart.

Record stock buybacks are fueling the stock market

At times, it's been tough to figure out what's driving the stock market higher. An accommodative stance on interest rates by the Federal Reserve is presumably helping spur lending among businesses, and helping consumers refinance. Low lending rates have also been instrumental in stabilizing and growing the housing industry.

Arguably, though, an even more-important driver of stock valuations in recent years has been stock buybacks. According to S&P Dow Jones Indices, stock buybacks during the trailing 12-month period have totaled $589.4 billion, which is the highest level ever recorded on a trailing 12-month basis. During the first quarter, buybacks for S&P 500 companies totaled $161.4 billion, which was the highest level since Q1 2007.

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As noted by Yahoo! Finance, the largest buybacks executed during the first quarter belonged to Gilead Sciences , Apple , General Electric, Pfizer, and McDonald's, which have been swimming in excess free cash flow, and have had the room to aggressively repurchase their own shares. Gilead Sciences, for instance, announced a $12 billion share-repurchase program in February, while Apple upped its shareholder return program -- which also includes dividends -- to $250 billion through 2018. Yahoo! Finance notes that S&P 500 companies have a combined $1.3 trillion in cash on their balance sheets.

Share buybacks are considered an attractive tool for big companies to deploy because it can have a positive impact on valuation. Repurchasing stock reduces the number of shares outstanding, which, in turn, means fewer shares in the denominator when dividing profits into outstanding shares. This, in turn, can boost a company's EPS, and possibly lower its P/E ratio, thus making it look more attractive from a valuation perspective, and maybe even driving its share price higher. It's viewed as an indirect way of rewarding shareholders.

This leading indicator could portend bad things ahead for the U.S. stock market

However, share buybacks hitting an all-time record high during the trailing 12-month basis could actually be a very bad sign for the stock market. It may be no coincidence that the last time Q1 share repurchases were this high, the stock market topped out, and subsequently plunged very shortly thereafter.

Although share buybacks can boost EPS and potentially make a company's valuation look more attractive, they also have a downside.For starters, share buybacks can mask business stagnation and make things appear better than they actually are.

In a simplistic example, if a company continues to repurchase shares each and every year, yet its net income remains stagnant, its EPS will rise, and it will give the perception of a growing business. Yet, in reality, there is no organic growth in the example above. The buyback gives a false impression of growth to investors, disassociating the stock from the economy -- and likely a reasonable valuation.

Image source: Best Buy.

Case in point: Big-box retailer Best Buy has been turning to share buybacks with regularity over the past decade as it struggles to compete on price and inventory with the likes of Amazon.comand other e-commerce giants. Since 2006, Best Buy's outstanding shares have shrunk from around 505 million to 350 million in 2016.

In 2006, Best Buy reported $1.14 billion in net income, which worked out to $2.27 in EPS. Yet in 2016, it recorded only $897 million in net income; yet its full-year EPS expanded to $2.56. Operating margin, operating cash flow, and free cash flow are all lower for Best Buy since 2006, but the share buybacks make it appear as if Best Buy's business has improved over the past decade.

The other issue with share buybacks is that they aren't an efficient use of capital. This isn't to say a dividend payment is necessarily much better, but at least shareholders see immediate benefits to dividends in their pockets.

Using cash on hand to repurchase stock implies that there aren't more-efficient uses of cash available to a business. In other words, hiring, research and development, and business expansion through acquisitions are implied as not being worth the investment when a company initiates a share buyback -- and if companies aren't willing to reinvest in themselves, it could very well be a signal that they're worried about macroeconomic growth prospects.

Take things in stride

In the grand scheme of things, we understand, as investors, that no bull market can last forever. Inevitably, there will be a U.S. recession, and at some point down the road, the stock-market correction will turn into a bear market. It's always possible that this share-buyback data could be signaling that we're in the very late stages of the multi-year bull-market rally.

Image source: Getty Images.

However, the smartest thing we can do as investors is to stay the course, and be true to our long-term investing strategy of buying high-quality companies. As data studies have shown, trying to time your buys and sells in the stock market over the short term rarely results in superior profits compared to just buying and holding.

J.P. Morgan Asset Management, using data from Lipper, showed that buy-and-hold investors pocketed gains of 483% if they held the S&P 500 tracking index from the end of 1993 through the end of 2013. Mind you, investors pocketed these gains even with the stock market plunging during both the dot-com bubble and mortgage meltdown. By comparison, missing a little more than 30 of the market's best days during this 20-year period -- around 5,000 trading days -- would have resulted in every cent of gains being wiped out.

In short, even if record levels of stock buybacks indicate that a stock-market drop could be on the horizon, I'd suggest sticking to your tried-and-true strategy of investing for the long term, staying diversified, and supplementing your wealth creation with dividend stocks and dividend reinvestment.

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Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool owns shares of and recommends, Apple, and Gilead Sciences. It also owns shares of General Electric and has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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