Buyback Bubble Pops! The Long Ways Down …

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!



4 comments on the article “Buyback Bubble Pops! The Long Ways Down …
  1. Excellent as usual.

  2. The housing bubble really reflects a change in how mortgages are financed. They used to be financed by the neighborhood banks, but are now financed by Wall Street and investors worldwide. The irony is that large investment companies lost track of how much they invested in the sub-prime mortgages. This is ultimately why Stan O’Neal lost his job.
    Another irony is that community connections matter less than corporate connections. To understand how this is true read this NewsVisual article:

  3. There is an article about real estate in this site, it said the price of housing still good in next ten years,”Supply and Demand for U.S. Residential Real Estate “

    Why the concept about real estate is different from really happen

  4. The crash in the price of real estate has been due mainly to the fact that Congress (Barney Frank, Chris Dodd) and Fannie Mae (Franklin Raines, et al.), were sponsoring the lending of money to people who couldn’t pay it back and doing so in huge amounts.

    Money was lent to people with no down payment, no equity, and no documentation. Homes were build to sell to people on these absurd terms. Banks invested in asset-backed securities that were based on ridiculous mortgages.

    Now the chickens have come home to roost. The bad credit risks are being expelled from the homes they could never afford in the first place. This produces a glut of homes on the market, which forces prices down in certain areas.

    However, don’t give up on residential real estate and sell the family mansion just yet. Mr. Obama is coming to the rescue with massive spending that will probably be followed by massive inflation. Now I lived for many happy years in Brazil during a time when inflation was never less than 20%. The happiest people during an inflation are those owing unadjusted debt and holding real estate. The reason is simple: you never really have to pay off a long-term debt in inflation. Creditors are wiped out. The cost of construction keeps going up and so does the value of your home.

    About the current price level of US homes, one thing you should consider when looking at the long term trend is the SIZE of the homes today, compared to homes, say, thirty years ago. A large part of the so-called housing bubble that appears on secular graphs is simply due to the fact that homes are getting bigger and better.

    Also, the price of a home also includes the price of the land. In the current crisis, we see that the fall in real estate prices has not at all been equal across the country. There is a study on this blog that suggests that the disparity of the land component in real estate prices from region to region will result in greater variations in price in a down market.

    The big question now, in my mind, about the real estate situation is how long Mr. Obama will remain if office. If he’s in power for eight years, following current policies, we might be in for a Depression, like FDR, followed by violent inflation. However, if he’s kicked out in four years, inflation will come sooner and perhaps not be as violent.

    But in either case, it seems to me that we have inflation somewhere in the future. This means, hold onto your long-term non-indexed debt and real assets and eventually, you’ll be better off. Of course, if Obama is in office for eight years, many will no longer be employed and won’t be able to hang on until better times.

    Fortunately, we now have term limits and won’t have to face FDR style economic policies for 16 years or more.


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