Over the long run, the direction of U.S. stocks is very clear: They head higher. Historically, when factoring in dividend reinvestment, investing in stocks returns about 7% annually. That's a good enough return to allow you to double your money once a decade, and more importantly, to handily outpace inflation so that you generate real-money returns.
But this doesn't mean hiccups don't occur from time to time. According to data aggregated by Yardeni Research, there have been 35 stock-market corrections of at least 10%, when rounded to the nearest whole number, in the broad-based S&P 500 (SNPINDEX:^GSPC) since Jan. 1, 1950. Some of these have been quite steep, including the dot-com bubble, which saw the S&P 500 lose half of its value, and the Great Recession, where the S&P 500 fell by as much as 57% from peak to trough.
Is the S&P 500's quarterly buyback data a warning to investors?
Stock market corrections are inevitable, and they're nearly always unpredictable. However, there's an indicator that, in hindsight, has tipped off two major stock market corrections in the S&P 500 over the past decade: aggregate share buybacks.
According to FactSet Research Systems (NYSE:FDS), which puts out a veritable gold mine of S&P 500 company buyback data each quarter, quarterly share repurchases fell from nearly $180 billion in 2007 in the quarter prior to the start of the Great Recession to less than $140 billion in the next quarter. These buybacks tailed off almost every single quarter throughout the recession until S&P 500 companies were repurchasing less than $30 billion in aggregate common stock in 2009. During this period, the S&P 500 fell by 57%
Once again, in 2011, we witnessed aggregate share repurchase activity fall from nearly $130 billion for S&P 500 companies to less than $90 billion the very next quarter. The S&P 500 wound up dipping 19% from peak to trough soon after, albeit the move lower in the S&P 500 lagged the drop-off in corporate share buybacks in 2011.
I'll give you three guesses what we're beginning to see again based on the quarterly buyback data -- and the first two guesses don't count!
In the first quarter of 2016, aggregate share buybacks neared the $170 billion mark before falling almost $40 billion in the second quarter and down to $115.6 billion as of the Q3 data release from FactSet. On a year-over-year basis, this represents a 28% decline in share buybacks.
It actually gets even scarier
Why are S&P 500 companies paring back their share repurchases? It's certainly not for a lack of cash! A FactSet Insight report from March 2016 found that S&P 500 companies, excluding financials, had a near-record amount of cash on hand: $1.44 trillion. In fact, since the beginning of 2007, the amount of cash S&P 500 companies were holding, in aggregate, has doubled. In other words, there's a real possibility that S&P 500 companies pared back their repurchases because they either believe economic uncertainty is imminent, or they believe their stocks are no longer a good value.
But there are other reasons to be concerned.
A Yardeni Research report this past week found that operating earnings for the S&P 500 on a trailing 12-month basis in the fourth quarter were $919.9 billion. Yet, as of Q4 2016, trailing buybacks totaled $536.4 billion and aggregate dividends paid totaled $400 billion (as of Q1 2017). In short, S&P 500 companies are paying out more in aggregate buybacks and dividends combined (101.3%) than they're netting in operating earnings. The last time this happened was in 2007, right before the Great Recession.
The data shows that energy companies are partly to blame, with some funding their buybacks and dividends with debt in order to buoy their share prices. But the real concern here is that S&P 500 companies can't continue to fund massive buybacks and/or dividend increases based on what they're generating in aggregate operating earnings.
Combined, all of this data would certainly give credence to the idea that a double-digit percentage stock market correction in the S&P 500 is probably merited.
Something to keep in mind
However, it's important for investors not to overreact to this buyback data, no matter how much of a correlation there's been over the past decade between substantial drops in buybacks and stock market corrections.
The reason is very simple: Buying great stocks at regular intervals and holding them over the very long term is a winning strategy. The data doesn't lie. Despite 35 stock market corrections since the beginning of 1950, a bull market rally has eventually erased each and every correction, many times within weeks or months.
A separate report from J.P. Morgan Asset Management found that buying and holding the S&P 500 for a 20-year period between Jan. 3, 1995 and Dec. 31, 2014 would have netted investors a 555% aggregate return, or 9.9% per year. Remember, this includes the roughly 50% drop during the dot-com bubble and the 57% tumble during the Great Recession.
If investors tried timing the market and wound up missing its 10 best trading days, this aggregate return was more than halved. If you missed a little more than 30 of the best days over this 5,000-plus day period, your entire return would be wiped out.
Even if a stock market correction looks to be more probable than not, the data suggests that buying high-quality companies at regular intervals and averaging into great stocks over time is one of the smartest methods of building wealth over time.