Wall Street strategists try way too hard to deliver a precise forecast of where the market is headed. They look at price-to-earnings (P/E) ratios, projected sales and profit growth rates, dividend yields and other measures to come up with a target price for stocks.

They’re wasting their time.

The actual price of a stock is determined far more simply. You only need to focus on the supply and demand for stocks.

For example, the investment firm Liquidity Trim Tabs looks at how much money investors have poured into mutual funds on a daily basis. On days when funds come into the market, the market typically goes up. The reverse is also true.

Yet as we’ve seen the last few years, most investors have been pulling money out of equity funds, parking their money in places like bond funds. Analysts at JP Morgan note that individual investors have pulled $370 billion out of equity funds since 2007. That should have led to a stock market pullback during the past two to three years, but the opposite has been true. The market has tacked on major gains in the current multi-year rally.

How do you explain the anomaly? You have to look at the supply side of the equation as well. Thanks to a wide range of stock buybacks (partially offset by new stock issuance from IPOs and secondary offerings), the supply of stock available for sale is now back down to 2006 levels, according to an analysis done by Bloomberg.

JP Morgan suggests companies have bought back three times the amount of stock that individual investors have sold, implying that supply is shrinking much faster than demand.

The trend continues in 2012
Even as the IPO market starts to heat up in 2012, creating a greater supply of shares on the market, the volume of stock buyback activity appears to be far higher. Young companies are issuing a few hundred million dollars in stock, but many blue chips are buying back billions of dollars in shares.

This table below looks at the biggest buyback announcements of just the first 10 weeks of 2012.

 

You’re looking at roughly $75 billion in stock being taken out of the market by these 24 companies alone (which ignores current major buyback programs that were already in place before the year began).

Some of this robust buyback activity can be attributed to interest rates hovering at generational lows. A number of companies such as Hasbro (NYSE: HAS), for example, have taken out loans simply to buy back stock.

Timing and buyback size are everything
Of course, many of these companies may be making a huge mistake if there shares are already near multi-year highs and their P/E ratios aren’t especially cheap. Case in point: Companies in the S&P 500 earmarked roughly 35% of their 2007 cash flow to buybacks, only to find their stocks plunge to much lower levels in 2008, after the buybacks had been completed. Had they waited until the market tanked, they would have shrunk their share counts much more aggressively.

Some companies may eventually regret parting with so much cash. Cable operators like Comcast (Nasdaq: CMCSA) and Time Warner Cable (NYSE: TWC) are buying back huge chunks of stock, even though dark clouds are starting to gather over their industry.

You shouldn’t necessarily see these buyback programs as an inducement to buy, either. Tech stocks like Qualcomm (Nasdaq: QCOM) and Motorola Solutions (NYSE: MSI) are buying back stock because they have too much cash, not because they are bargains. Each trades for more than 15 times projected earnings.

I like to focus on stocks that have a chance to reduce their share count by 10% or more, such as Applied Materials (Nasdaq: AMAT), Target (NYSE: TGT) and Marathon Petroleum (NYSE: MPC). Each stock trades below the broader market multiple of around 15 to 16.

What it means for the market
Regardless of what buybacks mean for a particular stock, it’s an unequivocal positive for the market. With fewer shares in play, earnings per share could spike to record levels when the economy rebounds.

Let’s use Home Depot (NYSE: HD) as an example. The do-it-yourself home improvement retailer had 2.3 billion shares outstanding in 2004, but after years of buybacks, that figure has shrunk to 1.56 billion. Back in 2004, Home Depot earned $1.89 a share. With today’s lower share count, that EPS figure would have been $2.82. Coincidentally, that’s about what Home Depot is expected to earn this year because net income is far lower than it was back in 2004.

But what happens when the housing market improves and profits rise back to 2004 levels? Home Depot would earn closer to $5 a share — a company record, by far. Home Depot could have been more effective at buying back stock only when shares were in a funk, but the company will still reap the benefits of 700 million cut in the share count.

And as long as the supply of stock remains restrained, the seeds are sown for further market gains down the road. J.P Morgan thinks of buybacks as “bullish fuel as investors will ultimately move back into equities.” They favor financial services stocks, which are already inexpensive, compared with the rest of the market, and thus could have a more dramatic impact on their share count if more shares are bought back.

Risks to Consider: These big buybacks would prove foolhardy if they are completed just before the next market downturn.

Action to Take –> Boosting earnings is one thing, but lowering the denominator (number of shares) in calculating that all-important EPS figure is also a solid move. And when the numerator (earnings) rises higher, EPS can really shine. Be sure to sort through the stocks in your portfolio to see how any buyback plans will affect the stock. And don’t forget to consider this when making any new purchases.

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