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 …


This is the fourth article in a series about Post-Modern Security Analysis.

The analysis of corporate governance

The term “corporate governance” came into vogue in the 1990s and now dominates discussion of ethics and morality in investment markets.

For five essays on “corporate governance” on this site, go here.
Stakeholders have different interests

Often, the pretense of “good corporate governance” has served to shield ethically-challenged management from critical scrutiny by ordinary investors — an exercise in hypocrisy.

However, the corporate governance movement has come up with one important concept: stakeholders. The view that a corporation has many different “stakeholders”, with different interests, is essential to Post-Modern Security Analysis.

Management still talk about “looking out for shareholder interests”, but the influence of other stakeholders can hardly be ignored, especially the stakes of various governments, labor unions, franchise owners, administrators of off-balance sheet assets, license holders, creditors, employees, trading counter-parties, out-sourced suppliers, down-stream customers, banks, and, last but not least, management itself.

The analysis of corporate governance and of the relative importance of various stakeholders should be the first step in Post Modern Security Analysis.

Determining the relative importance of various stakeholders

Investment securities are a combination of contractual agreements and legal requirements merged with expectations of customary behavior. Normal and reasonable expectations of the benefits and risks of a specific investment opportunity vary among the stakeholders in each case.

Corporate governance is a "can of worms"

For example, fifty years ago, common stockholders expected that most profits would be distributed to them in the form of dividends and that hired management would be content to provide faithful service for a fixed salary and occasional modest bonus.

More »


On August 12, 2020, the US Federal Reserve indicated that it intended to stay the course, postponing effective action that might ward off high inflation once the Obama “spending is stimulus” money hits the fan.

Storm coming

Non-independent Fed Chairman Ben Bernanke, running for reappointment, is not anxious to adopt strong, anti-inflationary measures that might be unpopular. The Obama administration desperately needs rising employment statistics to boost the President’s sagging popularity, while postponing the advent of inflation until after the 2010 elections.

Former Chairman Paul Volcker, renowned for his tough taming of inflation during the Reagan administration, has been neutered to a powerless position on Obama’s economic advisory board, giving the President political cover of the Volcker reputation, without substance.

Both Larry Summers and Tim Gaithner have gone on national TV to announce that Obama’s “spending is stimulus” actions would result in higher taxes. What this means is that Americans can expect to see both high levels of inflation with depressed employment (the result of higher taxes).

So, what this seems to indicate is that sometime in the future the US economy will hit a transition point when inflation will begin to kick in with a vengeance. Interest rates will soar. The value of long-term bonds will plunge. Equities will be squeezed by stagnant sales due to the continued recession and high borrowing rates.

Navigating the transition to an inflationary economy

The Federal Reserve’s record of timely action to prevent inflation is not encouraging, and barring something really dramatic (like Paul Volcker resigning from the President’s panel in protest), it seems that a transition to stagflation is in the cards.

The spread between short-term and long-term interest rates is now high and increasing. As the tipping point into inflation gets closer and closer, this differential should increase even more. In the process, holders of medium and long-term bonds will experience a loss of wealth.

At some point, long-term debt is likely to sharply fall in value. When inflation kicks in, the price of long-term bonds will stay down for a long time. Leveraged holders of medium and long-term debt will suffer severe losses.

Those who managed to take out long term mortgages on their homes at today’s bargain rates will suddenly appear to be financial wizards.

Companies that wait too long to ameliorate their over-extended positions will finding bond financing far to expensive and will have to consider raising cash by selling equity (forcing down stock prices) or by rolling-over short-term debt (forcing up short-term interest rates).

This means that rates on money market funds and short-term CD should rise as inflation hits, while prices of medium and long-term debt fall.

See: Money market funds will tell us when inflation is here.

A possible strategy for survival

If this scenario plays out in real life, the survival strategy today (August 2009) would be to get out of long-term securities (stocks and bonds) and hold quality money market funds. This means losing current income from current rates on longer term bonds and potential profits from a possible continuation of the rally in stocks.

However, history offers many examples of sudden changes in market perceptions. The question is whether the transition to inflation will be gradual, say over two or three years, or sudden — in two or three months.

For well over a year, there were many warnings of a potential crash in equity prices, but the actual event happened suddenly in September-October 2008, leaving investors with little time to exit.

See: Buyback Bubble Pops! The Long Ways Down …

Now, it may seem counterintuitive to go into cash in the expectation of inflation, since everyone knows that holding cash offers no protection against inflation. However, the logic here is somewhat different.

  1. When inflation hits, it may be sudden, not affording investors a chance to get out of bonds and equities.
  2. The interest rates on money market funds can be expected to rise quickly when inflation hits, perhaps exceeding the rate of inflation.
  3. Once money market fund rates confirm that inflation is indeed here with a vengeance, the investor can then reassess the situation, going back into bonds or equities as may seem advisable.

If an investor holds $10,000 in a bond yielding 10% today, and the interest rate suddenly jumps to, say, 18% when inflation hits, he or she will continue to earn income of $1,000 on that bond. However, by selling the bond today and going into cash, and then reinvesting after inflation hits at 18% in the same bond, the investor’s income would now be $1,800 — 80% more than simply holding the same bond.

There are reasons to suspect that the current rally in equities may not be sustained.

See: Formidable barriers to a bear market recovery

The storm flags are flying — warning of inflation. No one knows what will happen, however since the Crash of 2008 was a precipitous event, as was the enactment of the trillion dollar stimulus packages, it seems at least reasonable that the coming of inflation will also be quick and sudden.

So the question is, if you knew that inflation was suddenly to jump to 8% next month, how would you be best invested?


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