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Here’s why stocks could be in big trouble

Lawrence Lewitinn
Talking Numbers

Corporations have been on a spending spree, using huge stockpiles of cash to buy back their own shares. Is this what really has been pushing the market to new highs – and will the markets soon change course?

According to data compiled by Birinyi Associates, 2014 is looking like a banner year for share buybacks (a technique whereby companies buy back their own shares from investors, thus increasing the demand for their stock).

(Watch: Stocks climb on hopes for Fed, Chinese stimulus)

“The first half of 2014 has been the best start to the year ($338billion) since 2007 ($361 billion), the current record year for buyback authorizations and executions,” writes Birinyi analyst Rob Leiphart. “And since the bear market ended on March 9, 2009, the current quarter ($157 billion) is the third best (out of 22 quarters) during the current bull market.”

This matters because with fewer shares circulating after a buyback, earnings per share – a key metric in valuing stocks – are boosted even if net income declines. According to a recent study by Barclays, share buybacks are now responsible for about 2 percent of total earnings for the S&P 500. What’s more, companies that have the highest share repurchases have outperformed the rest of the market since mid-2008.

Gina Sanchez, founder of Chantico Global, pins share buybacks squarely on the shoulders of the Federal Reserve’s quantitative easing program. She sees the S&P 500’s recent record highs as a byproduct of buybacks, not high levels of revenues.

“It is shocking that this continues,” said Sanchez about buybacks. “What we have seen is continued evidence that all of this monetary expansion has found its way into earnings – [into] everything except for real demand and sales.”

Labeling earnings over the past five or six years as “just OK,” Sanchez said net income has only recently started to pick up. However, she believes investors have been buying into momentum over the past few years.

(Watch: Third quarter US growth outlook cloudy: Survey)

“People saw anything that propped up earnings [and] they bought right into it,” said Sanchez, a CNBC contributor, adding the warning: “Some of that is going to have to come out of the markets.”

Richard Ross, global technical strategist at Auerbach Grayson, agrees with Sanchez that share buybacks are tinged with Fed involvement. In the same way buybacks have supported share prices, so has the Fed’s bond-buying program propped the bond market and kept interest rates down, he said. But he doesn’t see that last indefinitely.

“At some point, both of these trends are going to end,” said Ross, a “Talking Numbers” contributor. For Ross, where the S&P 500 winds up depends on whether it can stay at current levels or if it tries to test the support level he sees around the 1,985 mark.

“What you don’t want to see is a move which takes us back below that 1,985 support and then we put 2,000 in the rearview mirror,” Ross said. However, he sees a pullback as likely, with a possible test of the 150-day moving average, currently around 1,914. That would mean a 4 percent decline from current prices.

“It would be healthy,” Ross said.

To see the full discussion on the S&P 500, with Sanchez on the fundamentals and Ross on the technicals, watch the above video.