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.

Now that litigators of class-action lawsuits have expressed concern as to the fairness of stock buybacks that dominate the equity markets, it is time to look beyond the rationalizations of Wall Street and try to judge the legal perils inherent in the buyback movement.

After all, if executives and directors come to find themselves in legal jeopardy, the buyback movement is finished and one of the pillars supporting equity prices will vanish. This is why capital flow analysis is relevant to the safety of your nestegg. We are not talking about sending greedy executives to jail, but about crashing the stock market!

A Growing Wave of Criticism

Over the last two years, criticism of buybacks has grown. As class action lawyers begin to look at the practice closely, they are likely to find previously overlooked legal vulnerabilities. And with buybacks running a trillion dollars every two years, it is well worth their time and effort.

As Sherlock Holmes might say, “The game is afoot!” A dramatic battle between lawyers and executives is beginning to unfold, with the potential of collapsing the stock market.

Legal ramifications of a corporate buyback are varied: there are questions of disclosure, market manipulation, insider trading, use of binding contracts, buybacks during distributions, tender offer rules, reporting of beneficial ownership, and compliance with short-swing profit restrictions … and more.

However, I would suggest that the reader consider just one common claim or suggested ’shareholder benefit’, put forth by corporations to justify buyback programs. This is the claim, hint, or intimation that buybacks are just a form of dividends — an equivalent way to distribute profits to shareholders, but more to the advantage of shareholders and to the company in terms of flexibility, efficiency, and taxes.

Are Stock Buybacks Really Equivalent to Dividends?

Now it is not necessary to go through SEC Rules 10b-18, 10b-5, 10b-5-1, 13e-3, 13d-g, and other regulations to show the fraud inherent in many stock buyback programs.

A basic principle of US security law is that material misstatements and omissions of fact in connection with the purchase and sale of any security are violations to be sanctioned.

So the question simply is this:

Is it true or not that stock buybacks and cash dividends are equivalent in any sense?

Are stock buybacks really as fair and beneficial to shareholders as dividends?

If not and if corporate executives have suggested otherwise, strict compliance with other SEC rules may be irrelevant. The corporate executives will have engaged in a material misstatement of fact in connection with the buyback program and will be liable.

How Buybacks Work

The basic pattern of a stock buyback program is simple (although the details are involved).

The corporate board, without prior shareholder approval, gives authority to corporate executives to repurchase up to a certain quantity of shares (or to spend a certain amount in buying back shares), most often without any commitment as to price, timing, or fulfillment of the program.

In an open market buyback, as long as executives follow the rules of the SEC and the limits set by the board, they may buy as many shares at whatever price and time they deem convenient.

In open market buybacks, shareholders are advised of the board’s decision but are in the dark as to the timing or execution of the program. Disclosure is partial and after the fact.

A shareholder has no way of knowing, when selling into an open market buyback, whether corporate executives intend to increase or drop the price of future purchases, or whether buybacks have started or have terminated, or whether a particular sale went to the company or to someone else.

The SEC rules DO NOT require that all shares be repurchased at the same price or equitably from all shareholders in proportion to their current holdings. As long as the rules are followed, executives can buy all shares from shareholder A and no shares from shareholder B. They can pay shareholder C ten dollars per share and shareholder D twenty dollars per share, as long as this is done in accordance with the guidelines.

Why Open Market Buybacks Are Materially Different From Dividends

Sometimes stock buybacks are limited by an overall monetary amount and sometimes the limit is only as to the number of shares. The mechanics of the buyback may differ, from a tender offer, a dutch tender offer, a private negotiation, or an open market buyback.

However, the majority of buybacks on the US market today are of the open market variety and it is this type that is likely to attract the interest of lawyers bringing class action suits for unfair dealing with shareholders.

Even if all shareholders were to decide to sell a pro-rata amount of shares into an open market buyback program, because of price variation, it is CERTAIN that these shareholders will NOT get their equitable portion of the funds distributed in this so-called “dividend equivalent”, as they would in the case of conventional dividends:

When buybacks are on the open market, each shareholder gets a different price per share, whereas in a conventional dividend, each shareholder gets the same cash payment per share.

In the case of dividends, there are no commissions to pay, whereas in a buyback program, shareholders must pay commission, some proportionately more than others.

Twenty years ago, when the buyback movement was starting, these programs were small relative to the capitalization of the company — perhaps only one or two percent. With small buybacks, the degree of ‘unfairness’ represented by the uneven distribution of price might be only pennies to the small shareholder — hardly enough to go to court about.

Today, however, buybacks run into billions of dollars and sometimes involve 25% or more of outstanding shares.

When considering a class action in the interest of shareholders of the many companies involved in buybacks, the cash flows total more than one trillion dollars and the ‘dividend differential’ runs into billions.

The Non-transparency of Buyback Programs

Shareholders receive conventional dividends automatically, even if they are dead, insane, or incompetent. To receive a dividend, the shareholder does not need to do a thing; being an owner is enough. The custodian bank collects the dividend and credits the shareholder’s account at no cost.

In the case of the “buyback dividend”, the shareholder must first be aware of the program and must be able to make the decision to sell in order to receive this so-called “distribution”.

It is also necessary to pay a commission to a stockbroker in order to receive this “dividend”.

Although corporations announce the board’s decision approving a buyback program, unlike a rights issue, tender offer, or other corporate actions, the company usually does not need to inform individual shareholders of this nor need they provide investors with information that might help in deciding whether to sell.

This is a peculiar blindspot in SEC “investor protection”. A voluminous prospectus must be mailed to each investor in the event of a public offering of only 1% of the capital of a major company, but a buyback program involving billions of dollars and 25% of the firm’s capital may pass without special disclosure.

Many buyback programs are conducted without the ultimate beneficial owners being aware of what is happening.

The Case of Shareholders Who Can’t Sell

But the “buyback-as-dividend-equivalent” argument really falls apart when one realizes that many shareholders simply may not be able or willing to sell shares to take advantage of this “distribution” of corporate cash.

• Shares pledged as collateral, or held in trust or escrow, or tied up in court due to divorce or probate, or held in joint names, may often be unavailable for sale.

• When shares have been purchased at a higher price than the current market, the shareholder must sell at a loss to take advantage of this so-called “dividend”.

• When shares have been purchased many years ago, the capital gains tax on a sale might exceed any supposed benefit of a buyback “dividend”.

In fact, about the only shareholders that will almost surely benefit from the “buyback dividend” are corporate executives exercising stock options at a convenient moment to sell for a guaranteed profit.

The Cherry on the Litigator’s Cake

Now let us imagine a class-action litigator bringing a case before a typical American jury, perhaps in rural Mississippi or in a high unemployment area of the rust belt.

Corporate executive claiming that “buyback dividends” really benefit shareholders who don’t sell because of increased earnings per share or book value are unlikely to find sympathetic ears.

After all, these juries will not be made up of financial MBAs and will have the common sense to know the difference between cold cash and ratios they barely understand and can’t be used to pay a widow’s medical bills.

But the cherry on the litigator’s cake is the question of motivation. It is not difficult for anyone to see that executives whose remuneration is tied to stock prices, often through stock options, have a direct and powerful interest in approving buyback operations, even to the disadvantage of ordinary shareholders.

To the executive’s argument that buying back a company’s own shares shows confidence in the future, the litigator need merely ask, “Why sir, were you then selling your own shares?”

And finally we have the image of the greedy, piggish corporate executive in the common understanding, supported in this view even by leading business magazines. Salaries and remunerations of tens and hundreds of millions of dollars simply do not endear these overpaid employees to the common working person. To the ordinary American, they reek of fraud and corruption.

It is not at all difficult to believe that corporate executives deliberately mislead shareholders when they claim buybacks to be just a more efficient form of dividends, and that they do so knowingly, in their own selfish interest, in violation of their fiduciary duty, and with the intent to defraud common shareholders.

And so, dear readers, stay tuned …