How Do Stock Buybacks Affect Stock Prices?

I saw a question on Quora about how stock buybacks affect stock prices, and couldn’t resist.

Do Buybacks Artificially Inflate Stock Prices?

Bathroom ScaleA stock’s price is supposed to reflect the value of the company. If a company has a million shares outstanding, and the stock price is $10, then the market is saying “this company is worth $10M.”

If that company then took some of its cash on hand and used it to buy back some of its own stock – say 100,000 shares – then the rest of the shares would theoretically re-price to reflect the $10M valuation.

The problem with that theory is that the cash which was part of the $10M valuation is now gone. The revaluation of the remaining stocks doesn’t make much sense because of the reduced cash-on-hand. The argument, (which I accept), is that the cash could have been used for more productive concerns which would have raised the profitability of the company which would then almost certainly be reflected in an increased stock price.

Stock buybacks bypass all the hard work of making the company more profitable. It is akin to a fat person modifying their scale to display lower numbers so they don’t have to do the hard work of actually losing weight.

Variables that Affect Gold Prices

Three economic variables that affect gold prices

The precious yellow metal is dollar-denominated. This means that when the price of the dollar moves, gold prices also shift. Both currencies are inversely correlated so when the dollar is down, the prices of gold go up and vice versa. According to historical data, the relationship between USD and gold are about 90% negative.

Gold prices get affected by littlest of things. This makes gold a good indicator of what’s going on in the global market.

Demand VS. Supply

Like any other commodity, the demand and supply of gold plays a huge role in determining its prices. Due to the limitations of gold, the supply is very much stable so demand plays a bigger part to its prices. You might be wondering why despite its limited resources, its current prices are on a steady decline. The reason for this is because of demand. Investment-grade bullion isn’t going up in prices now because it isn’t getting enough demand from investors. Today, gold prices are down because the dollar is very strong (inversely correlated) and investors are anticipating an interest rate hike in the U.S. next year. Gold doesn’t yield interest rates so people would rather invest in securities like bonds that produce high interest rates than commodities.

Inflationary warning

In recent years, central banks are buying more gold than they are selling. Gold bought by central banks in 2012 rose by 17% from 2011 at 534.6 tons. This was the highest level of gold buying by central banks since 1964, according to the World Gold Council. On the other hand, The Bundesbank – Germany’s central bank and quite possibly the world’s biggest support of the precious yellow metal – declared that it won’t be selling its gold until 2020. In 2003, Germany refused to sell any of its gold even if its prices were very low so it’s not surprising for investors to hear of such announcement. When investors see that central banks around the world are buying and keeping more gold, they deduct this as an act of preparation for a big inflationary threat.

Political unrest

When gold prices suddenly increase, there’s a huge chance that there’s something going on that can negatively affect the major currencies around the world. Gold is looked at as a secure way to keep assets in place when the future of a currency seems uncertain. During an invasion, the invaded country’s currency becomes worthless. But if people in that country have physical gold assets, they will have something to fall back on. This is the reason why gold prices spiked a little at the peak of the Russian invasion in Ukraine. The spike in gold prices during that time didn’t last long, but it’s a clear indicator that events like that affect gold prices.

In the end, gold will always be linked to currencies. The precious yellow metal’s value may decrease over time, but it will always be the metal used as hedge against uncertainty. Investors who want to have a good market outlook should regularly track gold since it’s very sensitive to factors that affect the economy.

Signs of a Market Crash

What are the signs of a market crash? According to Investopedia, a crash is “A rapid and often unanticipated drop in stock prices.”   A number of factors go into a market crash, but in the end, all those factors can be combined under a single heading: FEAR. Fear is both the cause of market crashes and the fuel for those crashes, so an early-warning system for market crashes must be focused on tracking and measuring fear. We have a number of ways to do that. The two most prominent instruments for measuring fear are the VIX and the PRICE/VOLUME combination.

A RISING VIX

Extreme emotions such as fear and greed birth extreme price movements. Another way to say that is that prices are more volatile when there is a greater-than-average amount of fear or greed in the market. In a market crash, fear is the dominant emotion and it feeds on itself, creating a feedback loop of plunging prices and increasing fear.

If we could measure the amount of price volatility in the market, we could have a better sense of the likelihood of a fear-driven event such as an impending crash. Fortunately, we have an objective way to measure volatility: the Volatility Index, or “VIX”. This index measures the magnitude of volatility in prices. The higher the VIX, the greater the degree of volatility in the market, which means the market is more prone to extreme price movements.

When the dominant emotion in the market is confidence, the VIX is low and price changes reflect that confidence by being fairly stable. When the dominant emotion in the market is fear or greed, the VIX is high and price changes tend to be more volatile.

So the first sign to watch for an impending crash is an increase in the VIX, which signals an increasing amount of extreme emotion in the market. The best way to do that is to chart the VIX and compare its price to its long-term average. If the price of the VIX is is rising, then price volatility is increasing. If the price of the VIX is above its long-term average, then price changes are more volatile than average. Combine those two – a VIX which is rising AND is above its long-term average, and you have a market which is ready to do something shocking.

VOLUME CONFIRMING PRICE

A rising VIX means extreme emotions in the market are increasing. But just knowing that volatility is increasing isn’t enough to tell us whether the dominant emotions are FEAR or GREED. The simplest way to determine which of these emotions is dominant is by checking Price & Volume.

When price changes occur on falling volume or lower-than-average volume, this indicates a lack of conviction. In other words, there is no strong emotion attached to such price movements. But when price changes are accompanied by rising and higher-than-average volume, this indicates more conviction, which can translate easily into more emotion.

There are two combinations of PRICE/VOLUME which can signal the onset of a crash. The first is a rising price accompanied by below-average volume and falling volume. This means that the conviction of buyers is drying up, and that there are fewer buyers willing to commit funds at higher prices.

An even more powerful signal of an impending crash is a bigger-than-average price drop on higher-than-average volume. This is a reliable signal that fear is entering the market and you should be ready to exit your long positions.

Note, however, that a big price drop on average or lower-than-average volume usually means that sellers are not motivated to close their positions, which means that – in spite of the price drop – there is an absence of fear in the market.

OTHER SIGNS & SYMPTOMS OF AN IMPENDING CRASH

When you have a jittery market, (as indicated by the VIX and the VOLUME/PRICE combo, an event external to the market can trigger a crash. Examples of this are the terrorist attack in September 2001, the runup to the Iraq war in 1992, and the passing of the Smoot-Hawley Tariff Act in 1930.  (Though passed in 1930, the prospects of the Act being passed in 1929 spooked the market and was a significant contributing factor in the 1929 crash. See http://www.polyconomics.com/index.php?option=com_content&view=article&id=2309:-75th-anniversary-of-smoot-hawley-tariff-act&catid=44:2005&Itemid=30).