Accelerating to a Buyback-Option Blowout

By Q1 2006, stock repurchases by domestic non-financial corporations had multiplied to five times the level of 2000, the peak of the Great Bubble of the 1990s.

Fuel on the Fire
Fuel on the Fire

With buybacks accelerating at an annual rate of 25% throughout 2005, and with net corporate profits after taxes increasing only 5.5% a year, it is now probable, if recent buyback-option trends persist, that by 2009 — the eve of retirement of the Baby Boomer generation — corporate stock buybacks will surpass net corporate profits after taxes.

Manipulating stock prices upwards by repurchasing equities requires ever-increasing levels of profits.

However, since reduction in corporate reserves is the inevitable outcome of increasing stock buybacks, failing to invest in the future leads to lower profits and will eventually bring buybacks to an end.

The question is not whether buyback-option programs can persist, but rather how long?

A Second Leg of the 2000 Crash?

The market crash of 2000 was triggered by foreign stock issues increasing and neutralizing buybacks of domestic corporations, to a point that the normal exercise of executive stock options created an excess of motivated sellers.

However, by 2005 corporate management had found a way to overcome the impact of foreign stock issues on their buyback-option plans. This consisted simply of increasing the volume of buybacks many fold, beyond what might have been considered acceptable five years earlier and beyond the market’s capacity to absorb new foreign stock issues.

By Q1 2006, resources needed to finance these new extreme levels of stock buybacks, together with the need to pay dividends, strained corporate reserves — forcing companies to issue bonds to cover the shortfall.

There are inherent instabilities in the buyback-option phenomenon (see The Buyback-Option Yin-Yang) that are only exacerbated by increasing the level of buybacks.

These instabilities, combined with buyback volumes that by now are accelerating faster than corporate profits and the rapidly approaching retirement (and expected equity sell-off) of Baby Boomers, suggests that a long-term bet on the U.S. stock market is far from a sure thing.

Professor Jeremy Siegel’s forecast of a 40-50% drop in stock values does not seem far-fetched.

Accelerants to the Coming Conflagration

Once the buyback-option phenomenon peaks and the market starts to crash, there are accelerants on hand, ready to aggravate the bonfire of values:

  • Increased Corporate Liabilities on Defined Benefits Pension Plans: A sharp drop in the price of equities will increase liabilities of corporate sponsors, drastically reducing profits and liquidity.

  • FASB Rule 142 on “Good Will Impairment”: For companies that have shown fast growth by mergers and acquisitions through the exchange of stock, with ‘good will’ building up on their balance sheets, a drop in equity prices will lead to large write-offs of profits.

  • Flight of Mutual Fund Investors: As occurred in the Crash of 2000, falling stock prices will spook long-term investors in equity mutual funds, especially those that are approaching retirement.

  • Panic among Option Holders: As prices fall, holders of executive stock options will be panicked into selling because most options have expiration dates and failure to sell today means less profits tomorrow.

  • Normal Shift in Asset Allocation by Aging Populations: After 2010, the number of people entering retirement will accelerate, leading to a natural shift of assets out of equities.

Is a Buyback-Option Blowout Inevitable?

It is impossible to foresee the future, but when you see a car rolling downhill towards a precipice, it is not wise to jump into the back seat for a ride.

Although some market leaders, such as Warren Buffett, have begun to speak out against stock buybacks, the majority of opinion makers in the financial press and among investment bloggers still strongly support buybacks and fail to link buybacks with options as the determining market force.

The market crash of 2000 has been generally attributed to speculative excess and poor accounting practices, as evidenced by the Dot Com Era and Enron.

The role of buybacks as shown in the Federal Reserve flow of funds accounts is generally not recognized or understood.

The big money that supports the financial press comes from people on the receiving end of buyback-option schemes: investment bankers, fund managers, and corporate executives. These interests are not likely to speak out against buybacks and options.

Financial bloggers are generally focused on speculation in individual stocks for short-term gain, rather than on the general trend of the market and the interests of long-term investors.

There are, of course, ways in which the buyback-option blowout might be adverted, such as banning stock buybacks, increasing restrictions and taxes on stock options, and changing tax incentives to encourage a substantial increase in cash dividends, while fomenting long-term investment.

However, just discouraging buybacks alone, without increasing cash dividends or limiting the exercise of options, would simply hasten a market crash, because equity prices are now dependent upon continuation of buyback-option programs.

Considering that the buyback-option trend has been building for a generation, it seems likely that the movement will run its course, which will be bad news for long-term investors who don’t understand what is going on and will stay in the stock market until the end of the game.

Literally, millions of people are in this category.

But not me.

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