Pretty much every economic theory rests on the idea that prices are set by the balance between supply and demand. If there are more buyers than sellers, or more demand than supply, prices will go up because the buyers will be bidding against each other. If there are few buyers, prices will have to go down to attract more buyers back into the market.
Which raises an interesting question: who are the buyers in the stock market?
Most people do not realize that one of the most reliable bulk purchasers of equities are companies themselves. Economists at Goldman Sachs have calculated that, in dollars, there was a greater volume of corporate buying than there was demand from pensions, mutual funds or households over most of the past decade.
In virtually all cases, these companies are buying back their own stock—some $923 billion worth last year. They actually contribute more than that in terms of supply and demand, because when a company buys back its own stock with excess cash, that stock is taken off the market—reducing supply. Some analysts think that corporate buybacks were a big part of why the S&P 500 gained 15% in price since the October low.
Why would a company purchase its own shares? Precisely for the reason that was just outlined: it drives up the company stock price, which serves shareholders. But of course, that money could alternatively have been invested in creating new factories, adding new services or research and development to build a larger and more profitable company. Share buybacks can be interpreted as a way of tacitly admitting that a company does not really know where to spend that cash on hand to benefit the company itself.
This article was written by an independent writer for Brewster Financial Planning LLC and is not intended as individualized legal or investment advice.