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!


Google has come out with a new service called Google Alerts that is a great tool for tracking the madness of the US equity market. Sign up and enter the words ’stock buybacks’ and each day your email will bring proof of the lack of market rationality.

Now, I’ve reported for some time (as many articles on this site attest) that buybacks have been driving the price of stock upward since the mid-1980s. Until the last year or so, however, most investors (as indicated by press reports) seemed unaware of this.

With Google Alerts, my email brings the news that things have changed:

  • The fact that buybacks are forcing stock prices upwards is now widely known, accepted, and (mostly) applauded;

  • The contention that price and value are equivalent has become conventional wisdom; an increase in stock prices due to buybacks is considered as boosting the intrinsic value of investors’ portfolios;

  • The combined effect of private equity plays and buybacks reducing the supply of equities is considered a good thing and healthy for investors’ well-being.

A few years back, the fact that buybacks were driving the market had not yet become common knowledge —this has now changed.

But wait, my ‘Googlemeter’ brings more news:

  • Corporations, in the aggregate, no longer have enough money to pay for stock buybacks out of cash reserves; they must borrow from banks to keep stock prices in the air. (This is confirmed by the Federal Reserve flow of funds accounts for the last year);

  • Rating agencies (never fast to condemn doubtful practices) have begun to downgrade the bonds of companies that are financing buybacks with borrowed money;

  • Banks are giving signals of reckless behavior (as they do from time to time, such as with margin lending in the 1920s, loans to Enron and Long Term Capital Management in the 1990s, and sub-prime lending recently) loaning money to finance buybacks — essentially giving depositors’ money (through the ruse of buybacks) to speculators who will never pay it back — and regulators, as usual, are unsure of what this all means.

Evidence that the investing public accepts this state of affairs is a sign that the market is in an advanced stage of its speculative fever, and that this, combined with indications that the market is over-priced in terms of dividend returns, portends that our patient will eventually swoon and fall to the ground.

The question is: when will this happen. (In other words, “Please daddy, can’t I stay in the market a little longer?”)

Waiting for someone to bite the tulip bulb

Folk tales of the speculative tulip mania in Holland in 1634-1637 circulate freely among Wall Street bears, along with the story of the (perhaps mythical) sailor who bit into a bulb, thinking it was an onion, thereby bringing reality to the market and crashing tulip prices.

Now, I have been working in capital markets for over two generations and have observed market psychology in booms and busts at first hand. I’ve also tried to warn clients in time to get out of dangerous markets in time and know by now that such warnings are generally unheeded.

The problem is that, although the signs of impending doom are there for all to see, no one can predict exactly when doomsday will come — tomorrow or two years from now —and investors want to hang on until the last possible moment.

I, for one, don’t know when the sailor will bite the tulip bulp.

The Look and Feel of the Top of the Market

Except in special circumstances, like the Crash of 1987, the end of a boom doesn’t usually happen on a single day. Here’s how the end will probably look and feel:

  • On a certain day, prices will start down, perhaps sharply, but then recovering somewhat at the end of trading. The talking heads on Neil Cavuto’s show will scream at each other: it’s time to buy; stocks are now cheap. Neil himself will say calmly, “I have great faith in American businessmen and women.”

  • The market will continue to back and fill, trending downwards. Investors will say, “Perhaps if the market gets back to the recent peak, I’ll sell a little.” The market probably won’t oblige, and, even if it does, investors will forget to sell.

  • After the market has fallen considerably, say 20%, brokers will undertake a massive campaign to ‘reeducate’ investors, saying “We’ve now hit bottom”. Professors from Ivy League colleges will be hired to attest that stocks are indeed cheap, by all the laws of ‘economic science’. Wall Street will remind the public of how those who have held fast have always done better in the long run. Investors, never anxious to sell, will be convinced and will continue to see their portfolios erode.

In other words, the best time to get out of the market is right now — before the crash. Sure, you will miss some capital gains as the market continues to move upwards and your friends, still in the market, will look at you as a fool, but you’ll have converted already over-priced stocks into hard cash while it was still possible to do so.

It’s hard to sell now, while the party is still in full swing, but it will be even harder when the market crashes and you carry the psychological burden of actual losses.

But of course, few people will follow the course of prudence. That’s what speculative bubbles are all about.


The US equity market may now be moving into a new phase dominated by massive arbitrage between the value of equities with and without stock buybacks.

As described in the article “US Equities: Wildly Over-Priced or a Great Bargain?“, the half-trillion dollar annual buyback craze that rules American equities has caused a gap to open between the value of equities held for the long-term and value to short-term speculators and those living off unrealized capital gains (like managers of open-end mutual funds).

The reason for this divergence in value is simply that cash paid out for buybacks does not go to long-term stockholders, but instead to corporate executives and short-term speculators.

As shown in the Price-PATAB chart in the article, stocks for the long-term have half of the value they would have if buybacks were paid fairly in the form of dividends.

Private Equity Steps into the Arena!

To take advantage of this divergence of values, vast amounts of money are being borrowed to take companies private. Once a company is private, control is transferred from hired-executives and fund managers into the hands of permanent shareholders. Corporate cash that was being diverted into buybacks can now go directly to shareholders, rather than executives via stock options or to short-term speculators.

Free from ineffective meddling by the SEC and the annoyances of Sarbanes-Oxley, private shareholders can now take control of corporate cash that was being channeled into buybacks, using what was to be buyback money to pay off loans that made the private-equity play possible — in essence, using the company’s own funds to take the company off the market.

Using corporate cash to acquire control, of course, is nothing new. What is different in the private equity movement is that cash dividends have fallen out of favor (See: “Harvard’s Breakthrough Idea: Don’t Pay Dividends!“), and buybacks now dominate the equity market (See: “Corporate Buybacks Continue at Record Levels: Q2 2006“), making it easy to find targets for private-equity-buyback arbitrage.

Private-equity plays are also different in that it is not really necessary to “clean up” a company, undertaking risky reform or restructuring, before putting it into the market again. The key is simply to divert buyback money to pay for ownership and then sell for a profit — essentially a form of slow motion arbitrage.

Of course, the booming trade deficit helps and is essential — money pouring in from abroad keeps interest rates low in the bond market and makes private-equity deals feasible. (See: “Hugo Chavez: The US Bond Market’s Friend“).

Will Private Equity Kill the Buyback Movement?

There is no reasonable doubt that most stock buybacks are unethical and fraudulent (See:”Stock Buybacks, Dividend Equivalency, and Securities Fraud“) and that these buybacks have been the driving force in the US equity market since the mid-1980s.

The question, however, is what will it take to bring the buyback movement to an end? Over the last few years, in this blog we’ve considered various possibilities:

  • Companies might run out of cash: Up until the market crash of 2000, it seemed that the buyback movement might end when companies no longer could generate the increasing amounts of money needed to continue to force prices upwards with buybacks. However, good economic times stemming from the Bush tax cuts, plus surprising corporate willingness to raid depreciation reserves and borrow to keep buybacks going, have driven buybacks to levels that seemed unimaginable in the pre-2000 years.

  • The government might step in: There was never much chance that the SEC or Congress would do anything meaningful to protect long-term shareholders from the plundering of buyback pirates, unless there was a major market crash, on the order of 1929 — an even then, probably not.

  • Lawyers and the courts might take action: Because buybacks are likely to shelter criminal activity, especially stock fraud, there is always the faint chance that the creaky US justice system might start to work against corporate executives and stock buybacks, sending a chill that will discourage the practice. (See:”Buybacks + Options + Hedge Funds + Inside Information = Crime?“)

  • Public opinion might turn: In the last two years, there has been growing criticism against buybacks, something almost unheard of prior to the crash of 2000. However, the Wall Street propaganda machine and the outright purchase of Congressmen and women, means that any progress along these lines would be a long hard slog. (See: “Investor Alert! Sarbanes Oxley Will Likely Be Gutted in 2007“)

  • Company executives might suddenly get an attack of morality: There was never much chance of this — not as long as the Harvard Business School continues to sponsor ethical ambiguity. (See: “Jeff Skilling Tells the Truth about US Corporate Ethics“).

  • Pressure from foreign new issues on the US equity market: Prior to 2000, this was an important consideration and, in fact, it was a major factor in the crash of 2000. However, Sarbannes-Oxley plus the growth of international markets has served to curb non-US corporate enthusiasm for issuing equities in the US.

The private-equity-buyback arbitrage play is an entirely new threat to the buyback movement, with greedy motives and massive funding giving reason to believe that this may, indeed, be the beginning of the end for buybacks.

Greed vs. Greed: A Winning Combination for Ordinary Investors

As long as executives try to use excess corporate cash and buybacks to push up their stock prices and give value to their options, they will be juicy targets for private-equity-buyback arbitrage.

Old line Wall Street firms, like Goldman Sachs, can not be happy with this new development, because any reduction in buybacks cuts off a valuable stream of income from SEC Rule 10b-18 and diminishes their profits — but, don’t worry, they will adapt. Moveover, relative newcomers, like the Blackstone Group are set up to feed off private-equity-buyback arbitrage and are raring to move into center stage. Just as Donaldson, Luftkin, Jenrette shook up the institutional investment market in the 1960s, the private-equity movement signals a major change in the market of the early 21st century.

Meanwhile, what will hired corporate executives be doing, once they wise up to the threat that private-equity-buyback arbitrage represents to their personal financial interests? From their point of view, a take-over is a take-over — someone else is going to call the shots and they won’t be able to put that Olympic swimming pool into their corner office after all.

So how should the smart hired corporate executive respond to this threat. Well, the answer is easy: start paying out buybacks in the form of cash dividends, fairly to all shareholders.

This would would raise current yield dramatically, driving up stock prices and eliminating the value discrepancy. It would give value to executive stock options, give cash to long-term shareholders, and reduce the potential for private-equity-buyback arbitrage. Last, but not least, corporate executives — for the first time in a generation — would be able to claim the moral high ground of actually paying dividends and high yields to small shareholders and retirees.

With corporate executives switching to big-dividend mode, for self-protection, and with private-equity gangs roaming the market seeking out unenlightened troglodytes who insist on buybacks and small dividends, the general level of stock prices should rise nicely, thank you — as long as the trade deficit continues to provide funds to finance this gigantic arbitrage play.

So maybe, after all, Gordon Gecko was right: Greed is good. The market will heal itself. Even the small investors might win.

At least until the Democrats manage to lose the War on Terror and New York City vanishes under an atomic blast. (See: “Victory in Iraq is not an Option — for the Democratic Party“)


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