Investment Theory: Sample Capital Flow Analysis

Corporate Equities

Supply and Demand for U.S. Equities

There has been a shortage of equities in the U.S. market for many years, as a result of households buying mutual funds through 401(k) and similar payroll deduction plans, without consideration of intrinsic value.

Inflation, fanned by fiat money, has resulted in a preference for investment in real assets by individuals, especially residential property.

Lost Overboard: The Dividend Anchor

Since the 1950s, household investors have assumed that equity funds would also provide protection against inflation.

However, this is reasonable only when stock prices are anchored by cash dividends, rather than by expectations of capital gain.

Unsophisticated investors have relied upon the Common Stock Legend.

Apparently, someone must agree with this commonsense view because individual investors have been net sellers of directly-held equities since the 1980s.

Unsophisticated investors have relied on the Common Stock Legend and have placed their trust in professional fund managers.

Although equity prices fell sharply in the crash of 2000-2001, prices still reflect considerable risk in terms of traditional measures of fundamental value.

Corporate Buybacks Limit The Supply Of Equities

Rather than meet strong demand for equities from naive buyers by making new stock offerings, domestic corporations have aggravated the shortage by repurchasing company shares in order to give value to options and executive remuneration schemes.

Domestic corporations have been net buyers of their own stock.

Domestic corporations have been, on balance, net buyers of their own equities, which along with the asset-lite movement and deindustrialization has contributed to a long-term slowing in capitalization of American industry.

This behavior has gone on since the early 1980s, with net buybacks totaling more than one trillion dollars in twenty years, causing equities to rise beyond long-term historical indicators of value.

Foreign Issuers Counter Domestic Buybacks

Foreign issuers have been the principal suppliers of equities to the U.S. market, offering new issues that neutralize domestic buybacks to some degree.

A high level of foreign issues helped trigger the crash of 2000.

In the aggregate, the supply of domestic equities must be linked to overall corporate profits, which over the last fifty years have not grown faster in real terms than the population.

Excessive Valuation Has Come To Be Accepted

In terms of valuation, U.S. equity markets are now highly inefficient.

In the stock market, most asset allocation decisions are made by unsophisticated investors, while professional managers are limited to selecting securities within the investor's asset-class.

Too many investors, too few stocks ...

Fund managers do not warn investors when stocks are over-priced.

They rarely close funds when reasonably-valued stocks are hard to find.

Uncritical acquisition of equity portfolios by the public has persisted for more than a generation.

Over-valuation Means High Volatility and Risk

Other institutional investors (pension funds, personal trusts, and insurance companies) also favor stocks, but move out of equities from time to time, contributing to market volatility.

Non-corporate foreign investors also have shifting interest in U.S. stocks, further influencing short-term markets.

With stocks generally over-priced, any decline in demand from either corporations (buybacks) or unsophisticated investors (tax deferred savings plans in mutual funds) will force stock prices downwards.

The Downside: Demographics And Commonsense

Since the current supply-demand configuration has persisted for twenty years, and since there are powerful interests intent on maintaining the status quo, there are few indicators, as yet, that either mutual fund investors or corporate managers will modify their behavior with regards to equities.

The current supply-demand configuration has persisted for twenty years.

However, demographics and other exogenous factors are likely to cause stock prices to eventually return to levels based on commonsense and intrinsic value:

An Unsanguine Outlook

Because of over-valuation, the probable effects of the retirement of baby boomers, and the unlikely continuation of buybacks for much longer, the outlook for portfolios of U.S. equities is negative, warranting caution.

May 2005

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