On September 17, 2020, 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!

If you are a long-term investor, holding your retirement nest egg in a diversified portfolio of US stocks, perhaps in an IRA or 401(k) plan, experts and the facts now suggest that your retirement assets are probably substantially over-valued in today’s stock market.

Many equity investors are not nearly as well off as they think — unless they are in the process of selling out today to invest in fixed income securities and a widely diversified portfolio of real estate income properties.

The question that long-term investors should be asking is how much do they risk losing by continuing to believe in the Common Stock Legend and the advice of their stockbrokers?

In the roar of Wall Street cheering about good times for equities, the chances that most equity holders will ask sensible questions about market values in time to save their assets is remote.

And, if and when they should ask, it will certainly be too late, because stock markets are not designed to withstand a rush for the exits.

Quantifying the downside risk in equities

It is possible to find serious researchers at prestigious universities and financial experts with articles in the Financial Analysts Journal that state that a fall of 30% to 50% from current market levels would be required for US equities to be ‘fairly priced’.

This means that that wealth held in US equities is probably over-valued by $3.3 trillion to $5.5 trillion! A readjustment to fair value would be painful, with serious economic and political consequences.

See: “Are GAO Projected Returns on Equities Reasonable?“

Most investors do not have the time, inclination, or skills to plow through the technical literature to find out whether stocks are over-priced. And the SEC will not help them.

However, investors do not need to rely on articles in Money magazine (supported by ads of Wall Street firms), or the Quicken ‘retirement planner’ (based on assumptions that the past predicts the future), or even on their stockbrokers (who earn a living by selling common stock and equity mutual funds).

By using common sense and some easily available statistics, John Burr Williams’ famous formula for equity valuation allows investors to check for themselves whether US equities, in general, are fairly priced or not.

As John Burr Williams pointed out seventy years ago, the sensible reason for long-term investors to hold common stocks is to receive a future stream of dividends paid by the company.

To build up wealth for their retirement, investors should put aside enough current income to provide for their old age, reinvesting dividends and interest received in the interim.

A prudent retirement plan: the essentials

No one can predict what the marketplace may be willing to pay for equities twenty or thirty years from now, when today’s retirees will need to sell investments.

However, with the anticipated crush of Baby Boomers needing money for assisted living and health care ten to twenty years from now, chances are good that ‘reinvesting unrealized capital gains’ in the hope of selling out many years from now is, at the very least, unwise.

A sound retirement portfolio is one that will throw off a dependable stream of cash dividends and interest, not only to provide income decades from now, but also to provide substantial current yields at that distant date so as to ensure that the value of a retirement portfolio is supported by cash payouts, so that, if it is necessary to draw down on the principal, the portfolio will be fully valued by the market.

Why US equities are 40% over-valued today

Here is how an investor might evaluate the level of US equity prices, based on John Burr Williams’ formula:

 

Input values of formula	Value
G= Dividend growth rate (based on S&P 500 dividends for period 1985-2006)	5.5%
I= Typical expected return for equity investments by American retirees	8.0%
John Burr Williams’ formula for evaluating one dollar of dividends	D/(I-G)
What current dividend yield should be, based on John Burr Williams’ formula	2.5%
Actual current dividend yield, based on S&P 500 (2006) stocks	1.77%
Market fall required to adjust S&P 500 current dividend yield to 2.5%	29.2%

See “The Value of Dividends” for an explanation of John Burr Williams’ formula.

 

In other words, given the S&P 500 rate of growth of dividends on US equities over the last twenty years, and popular expectations of return from long-term portfolios of common stocks (about 8%), equities, on average, seem to be over-priced by about 40% based on the current value of reasonable expectations of the future stream of dividends.

Considering that the annual growth of before tax US corporate profits over the long-term (1946-2003) was only 5.3%, predicting growth of corporate dividends at 5.5%, based on the S&P 500 dividends from 1985 to 2006, certainly does not seem to be overly-conservative.

So the two numbers needed for John Burr Williams’ equation, the 8% return expectation of investors and a 5.5% growth rate for dividends, seem to be quite reasonable.

Therefore, a drop of about 30% in stock prices would be required for equity investors to get the 8% return most expect when planning to fund retirement goals.

Corporate reform could dramatically improve equity values

Although, as indicated in the article “US Equities: Wildly Over-Priced or a Great Bargain?“, corporate earnings before buybacks are soaring to record levels, a huge multi-billion dollar chunk of this money is being diverted to the benefit of corporate executives rather than long-term shareholders.

If Corporate America were to suddenly reform, putting brakes on executive remuneration and redirecting buyback payouts into cash dividends, paid out fairly to all investors, then, indeed, Wall Street ballyhoo would be justified. Equities would be fairly valued and ordinary investors would be adequately protected.

However, since buybacks and corporate greed seem to be embedded in Wall Street culture, any investor who is willing to bet his or her retirement comfort on a sudden change of heart and sincere reform of rapacious executives, may deserve to be taken to the cleaners.

Expect continued irrational behavior

As pointed out in a previous article, if US corporations were to change their behavior, eliminating stock buybacks and using the money instead to pay dividends fairly to all shareholders, US equities would indeed by fairly priced and most retirement plans would be on track.

However, don’t hold your breath until that happens.

Uncontrolled, self-serving behavior of corporate executives taking advantage of an accommodating and dormant SEC and the unquestioning belief of the investing masses in the Common Stock Legend suggests that current patterns are likely to persist and that, therefore, US equities will continue to be substantially over-priced — until the next crash.