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Trader Notes: Are Buybacks driven the Stock Market Rally?

Definitely, YES. And they have the main credit for the stock market's rally since the 2009 crisis, and especially the latest years as they been reinforced during Trump's government due to the Tax Reform. It is enough to watch buyback' charts prepared by investment analysts to verify it, I add some of them below. 

Briefly, let's define the stock buyback. And what a better way to explain it that Investopedia, which defines that "a buyback, also known as a share repurchase, is when a company buys its own outstanding shares to reduce the number of shares available on the open market. Companies buy back shares for a number of reasons, such as to increase the value of remaining shares available by reducing the supply or to prevent other shareholders from taking a controlling stake." In days of a struggling economy, where get growth and profit increases are difficult, buybacks seem a good reason for companies to artificially inflate their share price.

Example of a Buyback

A simple numeric example, the best way to understand this, also taken from Investopedia: "A company's stock price has underperformed its competitor's stock even though it has had a solid year financially. To reward investors and provide a return to them, the company announces a share buyback program to repurchase 10 percent of its outstanding shares at the current market price."

Continue: "The company had $1 million in earnings and 1 million outstanding shares before the buyback, equating to earnings per share (EPS) of $1. Trading at a $20 per share stock price, its P/E ratio is 20. With all else being equal, 100,000 shares would be repurchased and the new EPS would be $1.11, or $1 million in earnings spread out over 900,000 shares. To keep the same P/E ratio of 20, shares would need to trade up 11 percent, to $22.22"

That's the reason:  no pay dividends, I prefer a share repurchase, which artificially raises the stock price. Great earnings season forever. Abnormally high levels of buybacks in the latest years generate an SP500 rising every year, despite real macroeconomic problems behind (incoming recession, Trade War and Brexit with no solution, inverted yield curve, manufacturing+services sector' contraction, negative interest rates, bond bubble, and so on). Investors, traders, people, Trump, and all Wall Street living a false illusion today, happy and carefree, hovering around its historical all-time highs. 

Check the chart below: this 2019 was especially aggressive in stock repurchase (yellow columns) above the 2010-2018 average (black columns). But, the year 2020 seems unpredictable. Probably the next US recession halts this situation as this can't hold forever.

Let's watch more crazy charts

In the following chart, Ned Davis Research measures the impact of share repurchase over the last nine years and found a significant effect. One of its four scenarios "buyback funds used to pay dividends" is shown above: watch that the SP500 would have been 10% lower. Given that growth stocks with high momentum have powered market gains since 2010, buybacks have been a particularly efficient strategy for creating shareholder return during this period.

In the next chart, Goldman Sachs compares the accumulated flows for different cases since the subprime mortgage crisis. Amazing the spread: yellow line shows money from SP500 stock repurchases (now $5 trillion!) growing every year since 2009, while other instruments as households, foreigners, and funds exhibit disappointing numbers. But, be careful, a recent report from the same Goldman Sachs warns that corporate buybacks are “plummeting” as companies tighten their purse strings, and it could have a big impact on the market. The boom may begin to slow in 2020: time for look for high-dividend stocks? Is the end of the bull market?

And last week finished the Buyback Blackout...

It is a usual theory on Wall Street that the market indexes dip during the days in which companies can't buyback its shares (usually a few weeks prior to reporting earnings and ends a few days after it). That period is called the blackout. It's incredible how the SP500 chart really whipsaws or corrects during the blackout periods, creating so a great key for well-informed traders.  

For short-term investors and swing-traders this chart is gold: shows that the buyback blackout period began to ease since mid-October, and today many companies are ready to repurchase its shares. And matches with October 26th, according to Seasonax, the historically day when begins the usual Christmas rally (if this year comes) and, seasonally, the best bullish weeks in Wall Street.

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Gilead, Illumina and Twitter Q3 Earnings this week

Three companies from my stock watchlist report Q3 earnings this week, all on Thursday 25 at the close of Wall Street's session: Gilead, Illumina, and the popular Twitter.

Traders love earnings' days. It's the right moment in which stocks get momentum and volatility, ideal for a quick day trade or a swing trade. One of the first rules of risk management in stock trading is don't traded longs or shorts before the ER, because it's just as gambling. Don't hurt your portfolio with bets. In that case, better use option spreads like the popular straddle ATM or buy a cheap call (or put) OTM, risking little capital with minimal, but existing, chances of a great profit.

The other way is taken by cautious traders: previously check chart trends, latest news of the company for key data, recent earnings surprise, insider trading, volatility, market sentiment, short-interest, and so. When earnings are published, checks and analyze quickly the main lines of the report (EPS, sales and guidance, if they beat or miss the estimates), buybacks and sensible data of the particular stock. Look at the trend in a tick-chart, read traders sentiment through chats (like Twitter or StockTwits) and wait for the conference call, usually an hour after the report, for more key information. A conference call could easily revert the stock trend and liquidate a hurried trade. The next day at the opening is a good idea to wait for analysts' reports and ratings: upgrade, downgrade, price targets, based on results. With all this information in our hands, it is more simple get a profitable trade.

Technical analysis seems unnecessary before an earnings report, but that's not true. Traders, investors, and smart-money always are looking at the charts for the previous levels and trendlines as a guide to limit the upside move ahead a good report, and similar for the downside. Let's review these three stocks:

1. Gilead Science GILD, $65.86

What an amazing and "clean" chart! The support at $61.40 is really strong, near six touches in this year. And above a clear resistance in its uptrend line. And today the price touching it again for 4th time in the year, and also at its SMA200 average! Depending on earnings, the price could explode and break any of the levels of this year-descendant-triangle pattern, easily $70, only in case of a positive report.

2. Illumina Inc. ILMN, $309.05

Since reach year lows in September at $263, Illumina began a decent technical recovery and now is t$309, the same level at which its huge gap closes in mid-July. Near $70 to fill that and its Q3 earnings could be the way for. The stock is gaining momentum last two weeks since the recent partnership with Qiagen QGEN to deliver in-vitro diagnostic tests. Take note that the biotechnology sector (followed by IBB ETF), saw some strength last week. Positive clinical readouts, a couple of M&A deals and hopes of drug companies clinching a broader opioid settlement worked in favor of the sector. A good earnings report could send this stock to $325-335, above the 50% of Fibonacci retracement.

3. Twitter Inc TWTR, $38.81

Ambiguous sentiment is perceived in this stock before its earnings report tomorrow, despite today is breaking down its strong support in the uptrend line shown, with increasing volume. I'm expecting great volatility, and prefer to wait tomorrow for deciding a trade. Usually, many analysts publish their ratings on this popular stock that finally decide the stock trend. Bad earnings report could send the stock to $36.90, its SMA200 average.

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Market Indicators give divergent signals

Although denied by several media, its macro data and yield curve say so: the US economy is entering a cooling cycle, a slowdown that is not yet a recession. The last data of Retail Sales was devastating: there fell the last hope of a stable economy after the Manufacturing sector's last readings confirm its contraction of several months, while the Non-Manufacturing is in a limit of 50.

While the US and China have achieved a commercial truce, which does not eliminate the uncertainty between the two countries, the above factors probably stimulate the Fed to reduce its interest rate at its next session. Add to this fact, that the end of the stock repurchase blackout is this week (the real engine of the stock rally). All this makes Wall Street live a false illusion today, happy and carefree, hovering around its historical all-time highs. Investors and cautious traders have already become aware of this panorama and are changing their portfolios, not closing positions but being more defensive. It is clear the situation does not only affect the US, but it is global: the Trade War is passing a very high bill to the global economies.

Some private indicators are reflecting this particular situation, markets high in a pre-recession economy, and are mostly neutral at the moment, although with a bias to change trends for the medium and long term.

Three indicators, different signals

1- The popular indicator 'Fear & Greed' of CNN Money identifies the emotion that drives the market. And today it's exactly neutral, increasing its value 8% since the previous reading. It works also as a contrarian indicator, that is, excessive greed is a bearish signal. It uses seven indicators in its calculation, one of them being notorious this time: this last week the volume of puts dropped to its lowest level in two years, a sign of extreme greed by bulls investors.
Another similar, the Bull & Bear indicator from Bank of America, not shown, this week rises its value to 1.9 from 1.2, being now in the limit between Buy or Sell signal (value= 2). Usually very accurate and follow by the smart money, the message is clear: don´t buy, just hold positions.

2- The last weekly survey of the AAII American Association of Individual Investors, showed a strong migration from bears to bulls, although this is still below average. This reads as optimism for the next 6 months. As it has historically proven to be also a good contrary indicator, higher increases over the current 33.6% can be interpreted as a medium-long term bearish signal.

3. This graph of The Conference Board chart reads alone: it shows that the CEO level of confidence in the economy behavior was below the 50+ positive level, reaching its lowest value since 2008. Usually, this happens during recession months (shaded in gray). Could it be that CEOs see economic problems before individuals of the AAII?

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Volatile days until Trade War meeting this Friday

After multiple downbeat economic reports earlier in the week, the SP500 SPX finally recovered little to finish the week down only 0.3%, thanks to Friday Jobs Report. Early week, poor numbers out of the manufacturing and services sectors, pushed the SPX down more than 1% for consecutive sessions for the first time this year. Friday’s jobs report showed that the U.S. economy added 136,000 jobs in September which was slightly below expectations, and the jobless rate dropped from 3.7% to 3.5%. This marked a 50 year low in the figure.

ISM index drive the markets

We already knew that the manufacturing sector has been struggling. Still, the ISM came in at 47.8, which is worse than expected. It’s the lowest number in more than 10 years, but not yet a recession (comes below 45). But last week it seems there was a "contagion". The ISM Non-Manufacturing Report was also below expectations. The reading was 52.6, which was the lowest in three years. Wall Street had been expecting 55. Since it’s above 50, we know that the Non-Manufacturing is still expanding, but it challenges the theory on Wall Street that the consumer is holding up the economy while the factory sector is in a recession.

This ISM Services number initially sent stocks sharply lower, but then quickly rebounded to finish higher on the day, when the SP500 touches its SMA200 average. Some felt that the recent data was bad enough to induce the Fed to lower rates twice by the end of the year (thanks to this week’s news, the odds of a rate cut are now up to 88% from 40%) making the bizarre case that Wall Street rallies on bad news.

According to Nomura Bank, usually very accurate in their technical analysis, the action level for the algos in the SP500 chart is setting this week in 2,970 for buy orders and 2,858 for sell orders and open shorts, that's near the SMA200 average. Today SPX is dropping 0.8% but is still ranging between those levels, waiting Trade War decisions, likely on Thursday.

Trade War: key to defining a future recession

The markets will be patiently awaiting the results of the US-China trade negotiations on Thursday and Friday. And it is all very clear, it is now up to Donald Trump to decide what will happen with the trade agreement, with the exchanges, and with the economy.

The Chinese have changed their attitude and now they see Donald Trump in a weak position, because his economy is already affected, because financial markets threaten to give problems, because they know he may have re-election problems if a recession is reached before the elections, and of course because he has many political problems (impeachment).

The Chinese Trade Minister has made it clear that they will not make any concessions. Without any doubt, they will not accept any of the great reforms that the United States poses. He has even expressly said that intellectual property laws will not change, one of the most conflicting points. But on the other hand, they have made it clear that they are willing to sign an interim or a "mini-agreement" immediately.

So, the definition is clear: Trump admits a "mini agreement" or there will be nothing. And evidently, the Chinese will stop buying agricultural products. If Trump accepts it, Wall Street will rally, but if Trump does not accept we can get into another descent of great proportions as much as he responds aggressively to all this.

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