On September 17, 2007, Capital Flow Watch called the top of the Buyback Bubble, issuing a warning that stock prices might be in for a sharp fall. Unfortunately, that comment turned out to be correct.

The outlook considered two simple facts:

• Stock prices are supported by equity buybacks, which, in turn, now depend upon loans for funding.
• The sub-prime mortgage event that started in July 2007 and the ensuing credit crunch, reduced money available for buybacks, weakening a support of equity prices.

This forecast was based on long-term trends concerning buybacks and equities, not on current numbers — the Federal Reserve publishes flow of fund accounts with a three month lag.

Now that we have the figures for Q3 2007, its possible to further access the situation and look forward.

US corporations are running out of buyback money

Federal Reserve flow of funds table F.102 (Nonfarm Nonfinancial Corporate Business) shows that in Q3 2007, corporate profits after taxes and dividends were at an annual rate of $232.1 billion. However, corporations were buying back their own stock at an annual rate of $446.8 billion.

Buybacks are no longer just “another form of dividends” as management has often claimed, suggesting profits as the source of funds. Rather, buybacks are now financed out of depreciation reserves, and most importantly, from borrowings. They are, in large part, a return of capital — mostly to people who never put up capital in the first place.

During 2007, credit rating agencies (often the last to spot danger), awoke to the risk of equity repurchases and began down-grading corporations that used debt to finance buybacks. Despite this, the buyback frenzy continues.

Moreover, in Q3 2007 something extraordinary happened: US corporations began to borrow abroad — in huge amounts. Because money is fungible, much of this went into stock buybacks.

In Q3 2007, the net increase in corporate borrowing from the “Rest of the World” was $232.7 billion, compared to annual rates that were often negative and never exceeded $28.3 billion from 2003 to 2006.

It takes ever greater amounts to keep stocks rising with buyback cash.

The flow of funds accounts reveal a grim picture. To give value to their stock options, executives, as a group, cut dividends to shareholders, diverted funds from depreciation reserves, issued bonds, even risking a fall in credit ratings, and , scraping the bottom of the barrel, so to speak, accelerated borrowing from aboard.

For equities, buybacks are the only game in town

Capital Flow Analysis is based on the premise that stock prices are not driven by earnings ratios, financial statistics, or “instrinsic value” (whatever that is), but rather by the raw force of motivated buyers facing more or less motivated sellers, as measured by the amount of money each party brings to the table.

In the equity market in Q3 2007, the principal buyers were (net flows, annualized):

Equity buyers Q3 2007, annualized

US nonfarm nonfinancial corporations (buybacks)	$846.0 billion
Insurance companies	$94.1 billion
Mutual funds	$58.0 billion
Closed-end funds	$31.5 billion

On the buying side, most money comes from buybacks.

Mutual fund net purchases of $58 billion (often representing automatic investment through 401(k) plans and IRAs), is way down from comparable figures of between $129.6 and $158.5 billion from 2003 to 2006.

On the selling side, comparable figures are:

Equity sellers Q3 2007, annualized

Households	$563.0 billion
Foreign equity issuers	$192.8 billion
Pension, retirement funds	$125.5 billion
Broker dealers	$52.7 billion

The motivation of the sellers is not hard to divine:

• foreign issuers are raising money in an equity market where capital is cheap;
• pensions, retirement funds, and broker-dealers are sophisticated players, selling because stocks are over-valued.

The motivation of the “households” category is also not mysterious.

This is a behavior that has persisted for a generation. Most household net selling represents corporate executives (and perhaps hedge funds going along for the ride) cashing out stock options.

The same guys on both sides of the market

So here we have the equity market in a nutshell.

On the buying side there are corporate executives ordering buybacks, using money that rightfully belongs to shareholders.

On the selling side we also have corporate executives exercising options and cashing in on buybacks they ordered.

Is this fair? Is this even a real market? Could there perhaps be a greater conflict of interest? What are the odds that corporate executives (wearing their executive hats) will overlook their greed and remember their fiduciary duty to shareholders?

No, no, no, and none.

Why ignorance is not bliss

As long as Wall Street and the Federal Reserve think that tinkering with short term interest rates will save the equity market, ignoring the effect of buybacks on equity prices and the motivation that drives the market, there is little chance that the outlook for equities will improve.

Here is why:

A corporate executive, once he or she reaches the pinnacle of power with a hand on the buyback lever, knows that this is a last and only chance to feed at a trough that has enriched so many for over a generation. If Wall Street is applauding buybacks and if shareholders don’t know any better, why not keep on feeding? Morality, after all, is based on common perception. No one has ever gone to jail for cheating investors through buyback schemes.

The SEC doesn’t care and even approves. The Federal Reserve says nothing and seems ignorant. Candidates of both political parties keep mum. Neil Cavuto, Lou Dobbs, and the Wall Street Journal have no comment. Fund managers and Wall Street analysts cheer each decision to increase buybacks. It is as if the Federal Reserve flow of funds accounts didn’t exist.

But buybacks are not free nor without consequences. They cost corporations their reserves against hard times, funds for long-term investment, and financial stability. This, of course, won’t stop executives who weigh cash in their own pockets today against the welfare of distant, almost mythical shareholders at some future date — when, as Keynes said, we all will be dead.

By weakening companies and eroding shareholder trust, a disservice is done to the system and to future generations, as corporate savings are diverted to non-productive ends. But never mind.

Even as stock prices fall, executives can find ways to readjust the value of their options downwards — after all, without stock options how could corporations attract “the best talent”?

So the only real brake on stock buybacks is how much money corporate executives can scrape from profits, reserves, dividends, and unwary lenders.

Sophisticated investors look elsewhere

From the Q3 2007 figures, we see that sophisticated investors and even mutual fund savers, are moving away from equities. As baby boomers being to retire and switch from equities to bonds, mutual fund interest in equities will decrease.

The credit crunch is certainly not over; big banks are being chastised for their profligate ways.

The rating agencies are onto the game.

Sooner or later the money for buybacks will dry up, but meanwhile, the market continues to fall as executives becoming more and more excited at the last chance to cash out their options.

An improbable solution

There is, of course, a way to stop all this.

The SEC, the Federal Reserve, and the political leaders would have to come together and condemn buybacks, insisting instead that if executives are to be rewarded for “performance” it should come through dividends paid to stocks that they, like everyone else, have paid for in full. After all, if this was good enough for Andrew Carnegie, why not for modern would-be moguls?

If this happened, cash dividends would shoot upwards. Stock would become worthwhile investments, based on dividend yields that, like in olden times, would surpass bond yields. Dividend yields would brake falling prices. Executives would be motivated to invest in the future and increase dividends. It sounds just like capitalism!

However, fat chance! Don’t count on it.
There are thousands and thousands of corporate executives, fund managers, and broker-dealers that know nothing else than the buyback culture. These people are not going away and have a lot of money to fight reform.

As for the economy saving the stock market, in the best of circumstances, it will take time to mend the banking system. A harder look at big loans for foolish purposes by weakened banks, will not help corporations anxious for funds to buy back stocks from their own executives.

With recession at hand, the American political outlook offers a return of the Clintons (with higher taxes and increased government regulation) or of someone like Mitt Romney, a former corporate executive, who has said that in the first crisis he would call in McKinsey & Company, the consultants to Enron.

Of course, there are good investments still out there, even among equities, and there will be even more as the recession deepens, but here we’re examining the immediate direction of the stock market, based on flow of funds analysis.

It is always somewhat foolish to attempt to call the top of a bull market or the precise moment when a speculative bubble pops, but sometimes its better to be foolish than sorry.

During the ides of July 2007, when the Dow Jones Industrial Average was gently massaging 14,000, signs appeared that air was finally beginning to leak out of the Great Buyback Bubble that has long characterized the US equity market.

The headlines were about a liquidity crunch, sub-prime lending, and banking risk, but the buyback band kept on playing, as if these events were in some parallel universe and that Mr. Increased Earnings Per Share, Ms. High Employment, and General Good Times were in charge and would keep equities moving up, no matter what.

However, from the point of view of flow of funds analysis, the ides of July 2007 brought bad news indeed for the equity market.

Why the July 2006 Credit Crunch Bodes Ill for Equities

The forces driving the market upwards have been more than evident for some time:

• Corporations have been aggressively forcing stock prices upwards by spending trillions in earnings, depreciation reserves, and borrowed funds on equity buybacks. Their motives have been simple and clear: companies need to win the approval of fund managers who control executive remuneration and bonuses and who are only interested in one thing: short-term stock price appreciation. The only way to guarantee that fund managers will be happy is to use buybacks to manipulate prices upwards.

• Individual shareholders have been vigorously selling holdings of equities, mainly to cash in executive stock options while prices are still high. For over a generation, individual direct sales of equities have exceeded purchases by a wide margin (now more than one trillion dollars every year and a half).

• Mutual fund holders, mostly ignorant of how markets really work, have continued to invest merrily in equities, hypnotized by SEC-approved Total Return figures (inflated by unrealized capital gains driven by massive buyback programs) and mutual fund marketing ballyhoo, unaware that buyback money is not going to them, the real owners of corporate America, but to executives, fund managers, and speculators.

The excess of buybacks over new issues now surpasses one trillion dollars every eighteen months — an astounding figure crushing all past records.

A Massive Ponzi Scheme

The dirty little secret about buybacks is that they are the essential element in a massive Ponzi scheme that favors corporate executives and fund managers.

As stock prices rise, it takes ever more money to drive prices even higher. When prices rise faster than the long-term rate of increase of corporate earnings per share (only about 5.1%), it gets harder and harder for companies to keep prices going up.

To raise money for buybacks, dividends must be cut, earnings depleted, depreciation and maintenance reserves forgotten, and “investing for the future” thrown aside. Even so, sooner or later the money simply runs out, the band stops playing, and equity prices fall.

For over a year, a large portion of buyback money has come from bank financing — a really stupid way for bank credit officers to apply depositor’s money.

The Liquidity Crunch

The significance of July 2007 to the Buyback Bubble was the sharp and sudden decrease in worldwide financial liquidity — which doesn’t mean that money disappeared — only that credit officers and investors suddenly began to come to their senses and realize the error of their ways.

After all, lending money to people without a job to buy real estate with no down payment at inflated prices is a far cry from rational lending practices.

Now bank credit officers are like any other pack of animals — they run the same way at the same time and are easily spooked. At the current extreme rate of buybacks, so dependent upon borrowing, any cut in buyback financing or glimmer of rational lending practices is really bad news for the equity market.

So the liquidity panic of July 2007 with its probable lingering consequences on credit policy, is the main reason to say that the Buyback Bubble has popped — perhaps not explosively, but decisively pricked nevertheless.

As companies find it more difficult to finance buybacks, executive option holders will be highly motivated to cash in their unrealized profits, as fast as possible, while there is still time. The volume of options held is so great, that any increase in selling will easily drive stock prices lower. As prices fall, more executives will have incentives to exercise options.

Joining them in the rush for the exit will be hedge fund managers, who have been going along for the ride and will note the end of the buyback bubble well before the unsophisticated masses holding mutual funds.

Finally, as prices fall far enough, mutual fund total return figures will become ever less attractive. Baby boomers approaching retirement will awake to the fact that you can’t live high on the meager dividends equities now pay; the rush to fixed income will begin. This will accelerate as interest rates rise.

Waiting for Hillary

While this rather glum background music is playing, we have to pass through the highly toxic atmosphere of US presidential politics.

Unless some miracle happens, it now looks like the next US president will be Mrs. Hillary Clinton, reigning with control of both houses of Congress.

Judging from what Mrs. Clinton has already promised her constituencies, here is what it would be reasonable to expect from her administration:

An increase in protectionist measures: This would tend to reduce the trade deficit, cutting the principal supply of easy money to US borrowers, sending up interest rates. The reduction in cheap imports from China and elsewhere will also drive up prices, tricking the Federal Reserve into raising interest rates to “fight inflation”. Higher interest rates will remove cheap financing for buybacks and drive stock prices down.

An increase in income taxes: Massive increased coverage for public health care, along with the need to repay campaign promises with increased government spending, will mean higher taxes and less money for consumers. This means lower corporate profits and less money for buybacks.

So, even if we lay aside the consequences of losing the War on Terror (seemingly, an almost certain consequence of a Clinton victory), there seems to be little reason to be optimistic about the outlook for the stock market.

Think 1973. Think Jimmy Carter!

Since 2003, the US dollar has fallen almost 50% against the Brazilian Real. What caused this to happen and what does it mean for the future of the dollar?

The reason for the strong real is the excess of Brazilian exports over imports, the result of government policy encouraging exports and discouraging imports. This has led to ever-larger dollar reserves.

Government policy resulting in extremely high internal interest rates attracts holder of these dollar reserves to invest in short-term Brazilian debt.

This is possible because of a convertible currency and dollar-real derivative products that allow foreign investors to take advantage of these high rates, while hedging against a possible decline in the value of the Brazilian real against the dollar.

Brazil has a cornucopia of valuable commodities to sell into world markets: iron ore, manganese, soybeans, coffee, cotton, castor seed, tin, rice, cashew, aluminium, black pepper, corn, and many other things.

In addition, Brazil has a powerful industrial base with low labor costs, producing everything from jet planes to automobiles to machine tools.

Brazilian exporters have a neo-mercantilist mentality, which means that they want to sell goods and commodities to receive hard currencies, primarily dollars. Brazilian economists and central bankers regard a surplus of dollar reserves as a good thing.

Heavy Tariffs Restrict Imports

The Brazilian authorities keep a large portion of export dollars by maintaining high tariffs and setting tough bureaucratic restrictions that discourage imports.

When all tariffs, imposts, and taxes are summed, the cost of imports landed in Brazil often exceeds 100% of the price received by the foreign exporter. These high costs protect local industry and keep imports lower than exports.

In 2006, Brazilian imports were 66% of exports. In Q1 2007, imports rose to 74.3% of exports. The resulting trade surplus exceeded Brazilian foreign debts.

High Taxes and Low Inflation

In recent years, Brazil has been able to overcome endemic inflation that has been the pattern for the last 400 years.

The key to this has been the imposition of taxes at a level that covers heavy government spending, soaking both the rich and the poor with value added, sales, and income taxes that eat up a large portion of the cost goods bought and sold.

Not only are taxes high, collection methods are intrusive. Residents of Brazil must have a tax number (CPF) that appears on checks, contracts, and bills of sale.

This makes it possible for the government to track individual spending habits and spot those with expenditures that seem to exceed reported income.

Big Brother is alive and well in Brazil.

High Interest Rates, Low Inflation, and Convertible Currency

Interest rates in Brazil, adjusted for inflation, are among the highest in the world.

This fact, together with a currency strengthening against the dollar, easily convertible, with availability of derivatives to hedge against currency risk, attracts foreign short term investment that further drives down the dollar against the Brazilian real.

The relationship between a trade surplus and interest rates that attract short-term investment, does not signal long-term weakness in the dollar, but rather a a temporary, short-term aberration brought about by Brazilian policies that are probably not sustainable in the long run.

The strong real against the dollar is already causing complaints from Brazilian manufacturers that are being priced out of world markets. Under employment and unemployment are high.

If current high-interest, high-tax, and hard currency accumulation policies continue, slow growth is inevitable and the poor in this lower middle income economy must accept living in poverty for the foreseeable future.

Why Things Are Not So Rosy

Despite the recent positive performance of the Brazilian real versus the US dollar, it would be a mistake to regard this either as a permanent trend or a sign that Brazil is now in the same category as successful economies like Singapore, Hong Kong, or Japan.

Although the rating services have upgraded Brazilian foreign debt, this paper is still one or two notches below investment grade. The GDP growth rate is now only 4.3%, far below the levels of the years of the Brazilian Miracle and insufficient to raise the standard of living of most Brazilians who are dreadfully poor.

Brazil is still classified by the World Bank as a Lower Middle Income Economy.

Although the left-wind government of President Lula has managed to stay in power by reducing inflation and by demagogic appeals to the masses, the price of rigorous inflation control is high taxes and high interest rates that repress economic growth.

Furthermore, the Brazil has an Economic Freedom Rating of only ‘moderately free’ and a Corruption Perception Index of 3.7 (out of 10).

Failure of Government’s Prime Responsibility

The Lula government has failed to maintain social order in major cities where drug lords and street gangs kill innocent citizens at will, daily.

No one knows for sure the death toll from crime in Brazil. One newspaper puts the annual homicide rate at 50,000 — a full scale war on a par with Iraq — while left-wing supporters of the government characterize the problem as “no worse than the United States” and “grossly exaggerated”.

However, the newspapers, which are still free, continue to herald the latest battle in a losing war against street crime, with news of daily shoot-outs between police and criminals, with lists of innocent civilians caught in the cross-fire.

The Girl from Ipanema now lies dead on the sidewalk, a victim of a stray bullet, as the posh bairro of Ipanema becomes what is described by O Globo as a war zone.

Residents fear to go into the streets of the major cities, even in broad daylight.

The dominance of criminal elements in society has grown steadily since leftist governments took over from the military in the early 1980s, and, with the end of the years of the ‘Brazilian Miracle’, crime should now be a major consideration in any economic evaluation of Brazil.

Dissatisfaction with the Lula government, which is generally characterized as corrupt, soft on crime, and and given to leftist folly, is evident from Brazilian newspapers or by talking with cab drivers in the large cities or people on the street. Something will give, sooner or later, and any significant political shift can cause the derivatives that now support the real-dollar rate to unwind.

How A Weak Dollar Signals Strength

If the dollar was not popular with Brazilian exporters and if the Brazilian government did not seek to build dollar reserves, there would be no excess dollars in Brazilian foreign accounts to swap into short-term Brazilian debt to take advantage of the high interest rates that restrain growth and inflation.

High real interest rates and taxes depress the rate of expansion of per capita GDP, which, in a country with an ever-widening gap between rich and poor increases political instability. The strong real against the dollar, reduces employment in the industrial sector, while easing up on import restrictions would damage domestic industry even more. With already high rates of unemployment, a strong real is not good news for the Brazilian economy.

Meanwhile, the rest of the world continues to build dollar reserves, as evidenced by the expanding US trade deficit.