The stock market's last line of defense is giving way

"Braveheart"/Paramount Pictures

Two things about human nature are pretty predictable. The first is that humans have short memories. Second, they never learn from their mistakes.

The same goes for investors. Markets change, the companies that dominate the markets change, technology changes, but human nature never changes.

Not that long ago we experienced a huge financial crisis where many people watched their 401(k) turn into a 201(k). While the markets rebounded to new highs in recent years, a lot of individual investors sold at the bottom and never got back in. Others who did, won’t know to sell until it’s too late.

Meanwhile, central banks have fueled yet another bubble. This one could be even bigger than the last, meaning that when it bursts, it will burst more violently. Carnage will ensue, and some companies will be more devastated than others.

That’s why I focus so much of my energy looking at earnings quality.

In my newsletter Forensic Investor, I publish stock recommendations betting against companies that use accounting shenanigans – basically, companies that have jimmied their earnings. Often, companies will resort to this funny business to mask deterioration in their business. I also design, develop, and test models to help spot financial chicanery and predict where earnings could be vulnerable to manipulation.

The problem today is that the whole market may be manipulated.

More and more companies use these “adjusted earnings” to report their financial results. They often exclude all sorts of stuff from the numbers to make them look a lot better than they actually are. Measures like EBITDA for example (or “earnings before interest, tax, depreciation and amortization) mask material weaknesses in the financials. Warren Buffet calls it: “earnings before the bad stuff.”

But the biggest prop to the market may be share buybacks.

Now, normally I’d say that buying back stock isn’t the kind of earnings manipulation trick that would cause the share price to sink. The share count is at the bottom of the income statement, and many other line items exist that management can use to generate income.

As an example, it’s far juicier if the company were cooking the books on the revenue line and overstating the demand for its product. That’s the sort of fancy maneuvering that causes a stock to implode.

But, we are not in normal times. The buybacks have gone berserk.

In fact, research from Wall Street’s biggest institutions suggests that almost all of the returns since 2009 have been driven by share buybacks.

I don’t believe that’s ever been the case before. That’s scary. But what’s scarier is knowing that after seven years, this bull market is very long in the tooth. Those buybacks have been propping up the market, stretching the cycle to the max. Take them away, and the entire market may collapse with them.

Take a look at the chart below:

"Braveheart"/Paramount Pictures

Just prior to the last crisis, buybacks surged. Then the market tanked, and share buybacks dried up during the best buying opportunity in a generation. Now that the market has rallied sharply since 2009, buybacks have accelerated again and are at all-time highs.

But, it may have topped out. Buybacks have started to fall off sharply in 2016. According to research from TrimTabs, buyback announcements are running 35% below the pace of last year.

And just over the past five weeks, the value of shares bought back have fallen 42% year-over-year.

This could really lead to trouble for the markets.

What’s more is that those numbers would look worse if you removed Apple and Allergan, which accounted for 54% of the volume.

But that’s not even the worst of it. Where it gets really ugly is that a lot of companies accumulated boatloads of debt to fund the buybacks. In the end, they’ll have balance sheets bogged down with leverage, and a bunch of wasted cash that was used to buy back stock at inflated prices. Little to none of that cash was spent investing in projects that could fuel future growth.

This could be creating a perfect storm that leads to much lower equity prices in 2016.

But it could also present one of the greatest opportunities to profit for regular investors like you.

It’s based on the same strategy I’ve used to manage my hedge funds through the last two market crashes. The deluge that will result from these buybacks not could, but will present another major opportunity to profit on the downside.

That’s why now more than ever you need to actually look at what’s going on behind the numbers companies are reporting with their earnings. Some of it’s true, but a lot of it’s B.S. I’ve put it all together in this presentation you can watch right now.

We’ve had two major scares in the market over the past nine months. I don’t think it’s going to get any better than it is right now, and the next correction could be the big one. Watch this presentation now and you’ll understand why.

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