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During 2013, many smart analysts and money managers voiced their puzzlement of why the stock market continued to rise in spite of the lack of revenue growth of many companies, a stagnating economy, and looming problems in 2014. I wrote in our Wellington Letter that this year it would have been more productive for analysts to just “go with the flow” and head for the golf course each day then to do tedious analysis.

Let’s look at the possible answer to the above question.

This year, companies have been buying lots of their own stocks. That has been a major driving force in this rally. Just about every other big investment group has been a net seller this year. Until May this year, $286 billion of buybacks had been announced. That’s up 88% from the same period last year, according to Birinyi Associates, a market research firm. They stated that at that rate, buybacks will exceed the record set in 2007.

Bill Gross. founder of PIMCO, the largest bond manager in the world, puts the amount of buybacks at $1 trillion per year over the past five years. He wrote recently:

“The U.S. economy – thanks to the Fed – has been operating a $1 trillion share buyback program nearly every year since late 2008, buying Treasuries but watching much of that money flow straight into risk assets and common stocks instead of productive plant and equipment.”

My goodness! If X can’t grow revenues any more, if X company’s stock has only gone up because of expense cutting and stock buybacks, what does that say about the U.S. or many other global economies? Has our prosperity been based on money printing, credit expansion and cost cutting, instead of honest-to-goodness investment in the real economy?

The Web site Zero hedge.com states on the subject:

“Nearly every other big player (other than buybacks) in the stock market has been selling more than they’ve been buying. Pension funds have been selling. Local and state governments have been selling. Investment brokerages have been selling. And, yes, until recently, even Main Street investors.”

Yes, it’s a shocking realization. I have not verified Bill Gross’s number, and in fact it’s much higher than that of Birinyi. I believe it’s more like $1 triillion over five years, not per year. Furthermore, I don’t know if they counted “announced” or actually executed buybacks. But even $1 trillion over five years is an amazing number. It’s an incredible thought that the driving force of the bull market in stocks may have been these buybacks. It has important implications for investors.

The Fed has not only been the great ‘enabler’ of the bull market, but also of Congress’s big deficit spending. Without the Fed buying up all these securities, Congress would have been much more frugal in running up the deficit. The limiting factor would have been the ability to sell the U.S. Treasury securities around the world. With the Fed buying almost all that is offered by the Treasury, there is no reason for the politicians to stop spending.

Currently, the Fed buys 80% of Treasury securities. Next year, it’s estimated to be around 120%. In other words, the stockpile of Treasurys in investors’ portfolios would shrink. Imagine, the Fed does all this with freshly created “cyber-money.” This is a big game changer in the 100 year history of the Fed. And that is the Bernanke legacy.

The buybacks have been enabled by the Fed’ ZIRP (zero interest rate policy). It doesn’t make sense for the companies to put hundreds of billions at less than 1% interest in CDs, money market funds, etc. Therefore, companies buy their own stocks.

Why is that a better investment? If you own the shares, like management or big investors, it’s great. Buybacks reduce the shares outstanding, and thus increase the earnings per share even if there is no real increase in profitability for the company. Therefore, stock prices rise, as we saw this year. It’s a beautiful game.

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At the same time, corporate “insiders,” i.e. top executives, have engaged in massive, record selling of their own stocks. Could it be that another reason for the buybacks is to enable insiders to sell at better prices? Someone should write a book, “How to make billions in stock profits without any performance gains in the company. “

The above would explain rising stock prices and rising earnings per share while sales are disappointing, and even declining for many firms.