According to Federal Reserve Flow of Fund tables for Q2 2009 (F.107 Rest of the World), non-US residents are moving out of US private debt instruments, favoring US Treasuries despite record-low interest rates.

The “flight to safety” which started with the Crash of 2009 has accelerated as the economic policies of the Obama administration are becoming evident.

The following graph shows a net swing away from selected private debt accounts on the order of USD !.5 trillion, between 2006 and Q2 2009:

Fed Flow of Funds Table F.107, US$ billions (annual flows) to Q2 2009
Fed Flow of Funds Table F.107, US$ billions (annual flows) to Q2 2009

This movement seems to reflect avoidance of three types of risk:

  1. OTC counterparty risk: Flight from security repurchase agreements and interbank lending reflects fear of sloppy trading and settlement practices in over-the-counter markets.
  2. Credit risk: Lack of confidence in the opinions of the traditional credit rating agencies grew even faster, following the Crash of 2008 and combined with the obvious risks of over-leveraging and difficult loan roll-overs due to the credit squeeze, to drive investors out of corporate debt markets.
  3. Inflation risk: Debt with the strongest credit and most efficient settlement markets cannot withstand a fall in value due to an increased rate of inflation. The Obama administration is doing what it can to scare bond investors away by gargantuan “spending is simulus” packages, passed in the dead of night, written by unknown parties, and unread by legislators or even the President.

Foreign flows to Treasuries and Equities at pre-Crash levels

Foreign net flows to US Treasuries, US$ B, to Q2 2009
Foreign net flows to US Treasuries, US$ B, to Q2 2009

After brief and sharp spikes during the last quarter of 2008, foreign flows into US Treasuries have returned about to the levels of 2004, and about twice the levels of 2005-7.

This seems to indicate that the panic of the Crash of 2008 has already subsided, but that there is no where near the amount of money available from the Rest of the World that would be needed to finance the Obama administration’s “spending is stimulus” packages in order to avoid inflation.

The non-debt foreign investment flows are indicated by the accounts “corporate equities”, “mutual funds”, and “foreign direct investments”.

Fed Flow of Funds Table F.107, US$ billions (annual flows) to Q2 2009
Fed Flow of Funds Table F.107, US$ billions (annual flows) to Q2 2009

These equity-type flows suggest that, following the boom years of 2006-2007, the appetite of the Rest of the World for US non-debt investments has returned to levels similar to those of 2004-2005.

In Q2 2009, foreign flows into US equities (annual basis) were $114.6 billion, compared to issues of foreign equities into the US market of $ 148.9 billion.

This means that by Q2 2009, the Rest of the World was, on balance, avidly avoiding new investment into US equities and private debt, while failing to show enthusiasm for financing the vast Obama stimulus packages which are coming down the road.

With these statistics and the historic importance of foreign investment in the US capital markets, one is left scratching one’s head, wondering why the US stock market was rising throughout the first half of 2009?



The US Federal Reserve flow of funds accounts for Q2 2009 provide a clear explanation of the causes of the recovery in stock prices in the first half of 2009.

These statistics show a pattern of behavior quite different from that which has prevailed since 1982.

It is too early to say whether Q2 2009 is the precursor of a new paradigm in US equity markets, or whether the Stock Buyback Era will return.

The (temporary?) demise of stock buybacks

For the last twenty years, the upward trend in the US equity markets has been driven by massive net stock buybacks on the part of non-financial corporations, matched, more or less, by huge net sales of equities by US households as corporate executives exercised stock options in amounts that far exceeded net stock investments by other individual investors.

New York City skyline in 1970s, before the Buyback Era began ...
New York City skyline in 1970s, before the Buyback Era began ...

During this period, prices moved upwards, which, according to the Motivation Axiom of Capital Flow Analysis, meant that corporate buybacks were causing the upward movement in stock prices.

In Q2 2009, this flow pattern was suddenly reversed — returning to a type of behavior seen prior to 1982 when the US SEC issued Rule 10b-18 granting safe harbor to corporations that wished to manipulate stock prices in order to give value to executive stock options.

The stock buyback movement has been, essentially, a trillion dollar Ponzi scheme that required ever greater gobs of corporate cash to succeed.

The Crash of 2000 signaled the first weakening in the buyback movement, as a point was reached where buybacks could no longer be easily financed just from current earnings.

The post-2000 recovery came about as corporations began to finance buybacks by dipping into depreciation reserves and, in the last five years, by borrowing from banks.

In 2007, the collapse of the sub-prime mortgage market began to restrict the availability of credit.

By the last quarter of 2008, imprudent bank lending had reached such proportions that global financial markets collapsed, bringing what seemed to be, the end of the buyback era.

Capital Flow Analysis made it possible to predict the 2008 collapse in equity prices as far back as September 2007.

Now the pattern has changed.

Radical shifts in market behavior in Q2 2009

Federal Reserve flow of funds table F.213 shows the dramatic difference in the equity market in 2007 (before the Crash) and in Q2 2009 (after the Crash):

Federal Reserve Release Z.1 (F.213 Corporate Equities)

Green = net buyers; Red = net sellers.

US$ billions (Annual rates) 2007 Q2 2009
Issuers of securities
Domestic, non-financial corporations -790.1 88.0
Foreign corporations 147.8 148.9
Domestic financial corporations 28.1 55.0
Exchange-traded Funds 149.9 149.0
Total Issuers -464.3 440.9
Purchasers of securities
Households -794.2 288.1
Federal government 0.0 -127.9
Foreign investors 218.5 114.6
Life insurance companies 84.1 15.4
Private pension funds -217.0 -170.6
State, local gov’t pension funds -35.3 2.8
Mutual funds 91.3 225.7
Closed-end funds 18.7 -7.9
Exchange-traded funds 137.2 106.7
Broker-dealers 25.4 -30.1
Miscellaneous purchasers 7.0 24.1
Total Purchasers -464.3 440.9

This table shows a striking shift in market behavior pre- and post-Crash.

Before the Crash, Domestic, Non-Financial Corporate issuers were net buyers of securities; after the Crash, these corporations were net sellers.

The 2007 pre-Crash flows were typical “buyback era” behavior — exactly the opposite of issuer behavior one might expect from Economics 101 in which corporations are supposed to go to the stock markets to raise capital.

After the crash, Issuers became “net sellers” and investors became “net purchasers” — which is what one would expect from Economics 101.

In Q2 2009, stock prices were rising and the principal buyers were individuals, directly as Households, and indirectly through Mutual Funds.

According to the Motivation Axiom, this means that the behavior of individual investors was the driving force that caused stock prices to rise in the first half of 2009.

By analyzing the flow of funds accounts for Households, we see that individual investors were moving out of fixed income investments into stocks, apparently due to low interest rates on short-term investments and fear of the impact of inflation on longer-term bonds.

What else can be deduced from Q2 2009 equity flows?

From the above table, other patterns can be discerned, beyond the shift of motivated buyers from domestic, non-financial corporations to households and mutual funds (individual investors).

  1. Rest of the world: Foreign corporations continue to use the US capital market as a source of funds (sellers of equities). However, the willingness of foreign investors to buy into the US equity markets has dropped significantly relative to 2007.
  2. Federal government: The US government is now a major player in the US equity markets. However, the government has not entered directly onto the stock exchanges, preferring direct deals with corporations. In Q2 2009, the government reduced their equity positions (net sellers) as companies sought to rid government from their lists of shareholders. The prices at which these transfers took place were not determined by supply and demand on the open market.
  3. Sophisticated investors: Insurance companies and broker-dealers tend to be more sophisticated in their investments than individual investors, acting directly (households) or indirectly through mutual funds. Sophisticated investors showed a reduced appetite for equities, despite rising prices. In the case of broker-dealers, activity shifted sharply towards net selling compared to their position as net buyers in 2007. This suggests that institutional investors might have been skeptical of the sustainability of the 2009 recovery in equity prices.
  4. Private pension funds: These long term investors have been strong sellers of equities since before the crash, indicating an excess of withdrawals over new investment in pension plans. As Baby Boomers retire in greater numbers, private pension funds might be expected to continue to be a drag on equity price levels.

These indicators suggest that the more sophisticated institutional investors have been avoiding US equities and that a furtherance of the 2009 price bounce may depend upon the motivation of less knowledgeable individual investors.

Risk of investment in equities increases substantially

For a generation prior to the Crash of 2008, with equity prices being driven primarily by corporate stock buybacks, investors could rely, over the medium term, in a continued rise in stock values.

The motivation the caused corporations to buyback their own stocks (at the expense of dividends and to the detriment of long-term investors) was pure, selfish greed, without a trace of fiduciary responsibility. This crass motivation proved extremely reliable, as seen by the behavior of top executives in saving their own remuneration schemes during the Crash of 2008, despite public outcries and the woes of ordinary investors.

However, if the buyback era is over — which is not yet certain — investors will have to get back to fundamentals and try to determine the intrinsic value of securities before trusting their life savings to a portfolio of equities.

This is easier said than done, since the market has changed since the days of Graham & Dodd.

Many unsophisticated investors still believe in the Efficient Market Hypothesis, as demonstrated by the continued high level of investment in Exchange Traded Funds.

Furthermore, the extreme, radical changes in the US economy being introduced by the Obama administration and the Democrat Party that controls the US Congress, with an outlook of fiscal deficits beyond anything most investors have seen in a lifetime (except in third world countries), combined with expectation of massive tax increases on most of the population (directly and indirectly), creates foreboding in the minds of most Americans (at least those who own stocks) as to the future of the country.

Furthermore, the are technical barriers to a continued recovery in stock prices, including:

  1. Over-hang of executive stock options: Corporate executives are still holding huge quantities of under-water stock options (perhaps on the order of a trillion dollars) that will be triggered if stock prices ever get back to 2007 levels.
  2. Rising interest rates: Sooner or later, the Federal Reserve will have to give up on trying to artificially hold down interest rates. When inflation kicks in, interest rates on money market funds will rise substantially, as happened in the Jimmy Carter years. At some point, investors will opt out of risky long-term investment in equities and move to tangible returns in the form of high interest rates.
  3. Persistent high unemployment and tight credit: Motivation towards increased personal savings are stimulated by high unemployment and tight credit. As seen in Q2 2009, personal savings rates have already risen substantially, causing savings to be channeled into equities, in lieu of extremely low interest on money market funds and bank time deposits. However, once interest rates start to rise and inflation kicks in, these savings may be moved out of equities into what is perceived as safer investments.
  4. Tendency to cash out of equities, once pre-Crash levels are reached: Most individual investors saw their net worth decline by twenty percent or more in the Crash of 2008 and many of these are approaching or are in their retirement years. Chances are that if stock prices ever get up to pre-Crash levels, these investors will be strongly tempted to cash out — placing a barrier to further recovery in prices.

In any event, uncertainty as to the future of equity prices has risen to the highest levels in a generation and uncertainty is just another name for risk.

We’ll see …


The Federal Reserve flow of funds accounts for US Households (Table F.100) clearly reveal the forces that drove the recovery in equity prices in the first half of 2009.

By comparing the flow of funds in the year 2007 (at the top of the bubble), with the flows in Q2 2009, a dramatic shift in investor behavior is evident.


Briefly, continued high levels of personal income, combined with lower taxes and historically low interest rates caused by Fed policies, along with fear of hard times to come and the need to save, resulted in a massive shift of funds out of fixed income investments into equities.

These statistics seem to contradict the dismal picture painted in the mass media.

However, by using commonsense and the Fed flow of funds statistics, the forces that influenced equity prices in the first half of 2009 are revealed.

Populist stimulus measures encouraged savings rather than spending

Both the Bush and Obama administrations pushed small amounts of money directly into the hands of consumers in an attempt to revive the economy in 2008 and 2009.

No Great Depression, despite political fear-mongers
No Great Depression, despite political fear-mongers

The theory, apparently, was that the public would spend these tiny payments, which in turn would cause businesses to produce more to meet demand, leading to rehiring and increased employment.

However, the public, frightened by rapid collapse of securities and real estate markets in 2008, and by dire warnings from the White House of a coming Great Depression — the haranguing of political operators not constrained by any need for historical accuracy — logically concluded that the prudent course would be to not spend money, but to save it for worse days to come.

The Federal Reserve, for its part, decided that lowering interest rates to almost zero would somehow encourage businesses to invest and create new jobs — presumably ignoring the terrifying behavior of a Congress that approved trillion dollar spending bills, without reading them, while favoring programs that would impose higher taxes on small businesses — the principal creators of jobs in the United States.

Rather than create new jobs, businesses became more productive, getting rid of marginal workers and holding on to the best.

Despite the success of the economic fear-mongers in getting the Democrat Party into the White House — the first president without any palpable executive experience — an over-whelming majority of Americans still had jobs and were willing to work harder to keep them.

Increasing the minimum wage resulted in sky-rocketing unemployment for young people — in the case of young black males reaching 50%!

The collapse of credit markets in the last semester of 2008 and the need for banks and other financial intermediaries to de-leverage as quickly as possible, restricted the flow of capital to business — despite the low interest rates.

Here are the figures that show household income, taxes, and savings in 2007 and Q2 2009:

Federal Reserve Release Z.1 F.100 Households and Non-Profits
US$ billions (Annual rates) 2007 Q2 2009
Household income 11,894.1 11,986.8
Personal tax 1,490.9 1,083.9
Effective tax rate 12.53% 9.04%
Personal savings 178.9 545.5
Savings rate 1.50% 4.55%

Here we can see that the tax savings doled out in the various stimulus packages did not result in greater spending, but in greater savings.

Only about 10% of the tax stimulus went into consumption — the rest was saved.

Furthermore, despite rising unemployment, household income did not shrink compared to 2007.

Switching from fixed income investments to equities

Not only did individuals save more in Q2 2009, but they shifted funds away from fixed income assets into corporate stocks.

Federal Reserve Release Z.1 F.100 Households and Non-Profits
US$ billions (Annual rates) 2007 Q2 2009
Net flows (annual basis)
Checkable deposits and currency -68.5 217.3
Time and savings deposits 422.7 -183.2
Money market fund shares 232.3 -147.8
Credit market instruments 468.3 -647.6
Sub-total (Fixed income and cash) 1054.8 -761.3
Corporate equities -794.2 288.1
Mutual fund shares 244.4 683.0
Sub-total (Equities and Mutual funds) -549.8 971.1

This table shows a remarkable change in the behavior of ordinary American investors between 2007 (before the Crash of 2008) and in Q2 2009 (after the Crash of 2008 and the introduction of Obamanomics).

The investment behavior in 2007 is easily explained, since it fits a pattern observed since 1982:

  1. In 2007, corporate executives were selling huge amounts of stocks (over $ 794.2 billion, annual rate) in order to take profits on their stock options. The main buyers were corporations with buyback programs approved by the executives themselves. See: The Great Misleading, a critical essay on the stock buyback movement.
  2. After the Crash of 2008, stock buybacks dried up due to lack of corporate funds. Stock prices fell to the point that most executive stock options were “under water”. Consequently, equity sales related to the exercise of options virtually ceased. There always were individual purchasers of equities, even in the buyback era, but the amount of such purchases was hidden by massive sales due to executive options. By Q2 2009, without executive options, 288.1 billion in net equity purchases became visible. The flow of funds accounts don’t indicate whether this amount was greater or less than underlying equity purchases in 2007.
  3. Bad credit and inflation threaten securities markets
    Bad credit and inflation threaten securities markets

  4. In 2007, individual investors still trusted Standard & Poor’s and believed that money market funds were safe. The table shows that in 2007, investors were taking money out of demand deposits and cash to buy longer term credit instruments.
  5. In Q2 2009, investors no longer trusted the credit standing of longer term issuers, moving money out of agencies, municipals, corporate bonds, and money market funds, into government guaranteed bank deposits and cash. Extremely low short-term interest rates encouraged this transfer.
  6. Massive, undisciplined spending authorized by the Obama administration in January 2009 cast serious doubts on the future of the US dollar, with a high probability of inflation. Individual investors acted rationally by moving away from medium and long term debt, in anticipation of the coming inflation.
  7. Individual investors, having suffered massive paper losses in equities in the Crash of 2008, held on to their long-term mutual funds, moving additional funds from fixed income into equities in the expectation of a market recovery. In part, this reflected continued belief in the Common Stock Legend, and in part a speculative reaction to the extreme lows of the Crash of 2008.

Increased savings, plus the above factors, go a long ways towards explaining the stock market bounce in the first half of 2009.

Is the 2009 bounce sustainable?

The flow of funds accounts for Q2 2009, extracted above, also suggest the reasons that the early 2009 bounce is not sustainable.

  1. The Obama health and cap-and-trade programs contain elements that will result in substantially higher taxes, direct and indirect on the American people. This will lead lead to higher unemployment and perhaps greater incentives to save for coming worse times.
  2. Sooner or later, the “spending is stimulus” programs of the Obama administration will result in higher inflation, raising interest rates on short-term money market funds and crashing medium and long-term bond markets. Inflation also tends to favor lower price-earnings ratios in equity markets, resulting in falling stock prices, at first.
  3. Corporate executives are still sitting on huge quantities of stock options that will become valuable if stock prices rise. If stock prices continue to rise to pre-Crash levels, executives will start selling stocks into the market. If credit continues tight, corporations won’t have the cash to support executive options with stock buybacks. This places a ceiling on continued equity price recovery.
  4. Baby boomers, with equity portfolios already severely damaged by the Crash of 2008, will be anxious to sell stocks as soon as prices begin to reach pre-Crash levels.
  5. The anti-capitalist slant of the Obama administration and the Democrat-controlled Congress, in the final analysis, is not conducive to a long-term rise in stock prices. Obama shows no indication, so far, of “moving to the center”. Although the President’s popularity is falling rapidly, the earliest date at which the current administration can be out of office is 2012.

If the Obama administration insists on continuing current policies, portending high inflation and increased unemployment, the United States may indeed be in for a Great Depression.

However, fortunately, unlike in the 1930s, a US President is now subject to term limits and the majority of voters are not union members.

We’ll see …


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