The Efficient Market Hypothesis continues to impede understanding of how capital markets work.

The front-page article in the WSJ of June 12, 2020, announcing record levels of stock buybacks, continued to promote a common misperception that stock repurchases enhance equity prices by the following mechanism:

  1. By reducing the number of shares outstanding through buybacks, earnings per share increase;

  2. Investors, noting this increase in earnings per share, are willing to pay higher prices;

  3. Therefore, buybacks. by increasing earnings per share, cause prices to rise.

This, of course, is in line with the Efficient Market Hypothesis, and depends upon the assumption that increasing earnings per share improves intrinsic value and that a crowd of rational, competing, profit-maximizers will therefore force prices upwards.

Ignoring the Evidence

The popular line of reasoning of the WSJ ignored Federal Reserve flow of funds accounts that showed that something far removed from the Efficient Market Hypothesis was driving the market in Q1 2006:

  1. Corporations were spending vast sums (more than $146.7 billion) to take stocks off the market with the intent of directly manipulating prices upwards;
  2. Individual, sophisticated investors, dealing in specific stocks, were not bidding up prices because of enhanced earnings-per-share, but rather were selling out on a grand scale ($216.6 billion) — cashing in their stock options;
  3. Unsophisticated investors (according to surveys by the Investment Company Institute) were naively buying ’stocks for the long run’ through automatic payroll deductions channeled to tax-deferred mutual funds, with no perception, whatsoever, of changes in earnings-per-share of individual securities.

The WSJ interpretation of the record level of buybacks, supported by the Efficient Market Hypothesis, puts a spin on events that is far kinder to corporate executives, stock brokers, and option exercisers, than the unvarnished truth that prices were supported not by improved earnings per share and crowds of rational investors seeking ‘intrinsic value’, but rather by the brute force of $146.7 billion in corporate cash being applied to take stocks off the market from option holders, many of whom were the same executives ordering the buybacks.

Furthermore, what was going on in Q1 2006 was not some random event — mere noise in the market — but rather the continuation of a long-standing pattern of behavior involving corporations, option-holders, and mutual fund investors that has been going on for many, many years.

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The Federal Reserve national flow of funds accounts for Q4 2005 confirm a remarkable and disturbing new trend in corporate behavior that seriously undermines the intrinsic value of the U.S. stock market.

Over the last five quarters, the annual rate of dividends paid by U.S. non-financial corporations has fallen by two-thirds, from $462.2 billion to $160.5 billion.

(See flow of funds table F213.)

The apparent reason for this negative trend is the intent of corporate management to radically increase stock buybacks in order to boost the value of executive options.

The discounted cash flow basis for stock valuation, which has been accepted by serious analysts since the 1930s, defines the intrinsic value of equities as a function of the projected rate of growth of cash dividends.

Now we have a situation in which the rate of growth of dividends is negative, and this is not a fluke occurrence in a single quarter, but a real trend that seems likely to continue.

Furthermore, the reduction in dividends has not been to reinvest in the company in the immediate term, with the objective of increasing future dividends.

Rather, the purpose has been solely to divert corporate profits into the pockets of executive managers by manipulating prices upwards in spot markets to give value to stock options.

(See: Essays on Stock Buybacks.)

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Long-term investors in equities continued to be disadvantaged by corporate executives who favored stock buybacks over cash dividends.

If it were not for the practice of distributing earnings as buybacks, instead of as dividends, dividends could have been increased by 176% which would have been greatly to the advantage of long-term investors, rather than speculators, fund managers, stockbrokers, and hired professional executives.

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