Flow of Funds Graph: US Stock Market
Case Study (Continued)
Flow of Funds Graph: US Stock Market: the Great Bubble
Graphing the Flows
In order to better see the relationship between supply and demand in the equity market, we have taken the raw data from flow table F.123 , and after arranging the sectors in groups with similar motivation, have plotted the net purchases and sales from 1985 to 2003 (see the graph, below).
Three groups of players stand out:
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The Corporation-Mutual Fund Buying Group: The green bars show net purchases by corporations and mutual funds, two groups strongly motivated towards influencing short-term prices in the stock market.
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The Smart Institutional Investor Group: The light blue bars show the net equity portfolio purchases or sales of pension funds, insurance companies, and personal trusts — a group we call 'smart' institutional investors because, unlike mutual fund managers, they were not operating on automatic pilot, investing blindly according to the fundamental investment strategy of their funds.
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Domestic Households and Foreign Investors: Domestic households and foreign investors, as a group, were net sellers of equities in all but two of the nineteen years, 1985-2003.
Corporations throughout the period were buying back their shares in order to give value to executive stock options, and mutual fund managers (who had some control over corporate executives by voting the shares in their portfolios) were intent on 'performance', defined as short-term total return.
Investors in equity mutual funds believed in the Common Stock Legend and had little understanding of the intrinsic value of the underlying assets of these funds, trusting in corporate management, fund managers, and the SEC.
Since the graph shows prices rising from 1985 until 2000, this group included motivated buyers that drove the Great Bubble and who were primarily responsible for rising stock prices.
These institutions either report directly to their clients (as in the case of personal trusts), or are liable for the long-term results of their investment (as in the case of insurance companies and pension funds).
These 'smart' institutional investors have the flexibility to invest or not in equities according to their estimate of intrinsic value of this asset class.
'Smart' institutional investors were net buyers of equities until 1994, but thereafter, once average price-earnings ratios began to exceed the long-term average of fifteen, this group became net sellers.
Significantly, in 1999 they were heavy net sellers, directly challenging the buyback strategy of the corporations and less sophisticated investors in mutual funds, signaling the end of the Great Bubble.
Generally, households were passive sellers, not driving the market but taking advantage of attractive prices resulting from corporate buybacks and the popularity of mutual funds for retirement savings.
However, whereas domestic investors were net sellers in every year but one in the period 1985-2003, foreign investors were generally buyers.
Between 1997 and 2001, foreign investors played a significant role in driving prices upwards, with net purchases reaching $193 billion in 2000.
When 'smart' institutional investors were stepping up net sales of equities, foreign investors were accelerating their purchases.
This suggests that foreign portfolio investors, along with domestic individuals buying mutual funds, were the sheep that were fleeced in the Great Bubble.
On the graph, there are several things to note.
The first is the sharp fall in the net buying action of corporations and mutual funds in 2001 and 2002 (the green bars).
Domestic corporations had become constrained by the natural limits on buybacks relative to profits, while foreign issuers were stepping up new issues.
Another highlight is the massive withdrawal of 'smart' institutions from equities in 1999 (light blue bars).
By 2000, rising stock prices had become dependent upon the doubtful ability of domestic corporations to finance buybacks in ever larger amounts and the willingness of foreign individuals to continue to pour record amounts into U.S. equities.
The graph shows that prior to 1993, although traditional flows from investors to issuers had been reversed by the buyback movement, prices were still reasonable and flows showed a more or less even pattern.
After 1993, prices began to enter the realm of the unreasonable and the net buying and selling flows progressively increased.
By 1995, the 'smart' institutions were bailing out of the market.
An Abundance of Signals
A strong bull market must be fed by an ever-increasing buying volume from motivated purchasers.
When this volume begins to fall, so does the market.
The graph (above) shows that this is what happened during the Great Bubble.
From 1992 to 2000 the amount of buybacks and mutual fund purchases steadily increased until the volume could no longer be sustained and the market collapsed.
Capital Flow Analysis provided an abundance of signals that it was time to get out of the stock market in 2000:
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PE's above Twenty: By 2000, it was clear that equities were vastly over-valued relative to all historic measures of intrinsic value. When the S&P 500 index reached twenty, in 1996, it was a signal that prices were in a danger zone.
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Institutional Sellers: Heavy net selling of equities by 'smart' institutions in 1999 signaled that sophisticated institutional investors were no longer supporting the Great Bubble. The actions of 'smart' institutions showed that traditional market forces were beginning to function.
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Foreign Issuers: The extraordinary level of new issues by foreign corporation in 2000 signaled that, whereas domestic corporations had limits on their ability to drive prices upwards with buybacks, foreign issuers were under no such constraints and could continue to sell shares into the U.S. market, neutralizing the upward pressure on prices of domestic stock buybacks.
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Individual Sales: An extremely high level of net sales by individuals in 2000 was the final signal that the Great Bubble was over and that it was time to sell equities.
Flow of funds accounts, of course, gave no forewarning that the peak would come precisely in the summer of 2000.
However, by that time there was enough capital flow information published by the Federal Reserve that a prudent investor would have known that, once the market turned, to continue to hold stocks was not a wise course of action.
A Long Ways Down
Despite the great loss of wealth, the Crash of 2000 did not send stock prices down so far that the S&P 500 index was again at the long-term average of fifteen.
The Great Bubble had definitely burst, but, in historical terms, stock prices were still high, suggesting that there was reason to be wary of further weakening, even as late as 2005.
The Crash of 2000 showed that corporate buybacks cannot push prices up indefinitely. Sooner or later, the accumulation of options in the hands of executives, plus the attraction of low capital costs on foreign issuers, causes buybacks to be neutralized and the market to fall.
By 2005, although buyback/option behavior continued, the market was beginning to enter the earliest years of the period when Baby Boomers will retire, putting new selling pressure on stock prices.
This suggests that, although prices did not drop to fifteen times earnings after the Great Bubble, this could still happen.
The market still had a long ways down to reach the historical level of fifteen times earnings.
No 'Paradigm Shift'
Despite the crash, the underlying motivation of market movers remained unshaken and unquestioned.
Attitudes of the market players that dominated the Great Bubble were not transitory or subject to sudden change.
The crash occurred not because corporate or mutual fund managers repented their short-term ways or because mutual fund investors had given up on the Common Stock Legend.
The market turned simply because stock prices had gotten so high that foreign corporations were persuaded to issue new stock, 'smart' institutional investors were convinced that intrinsic value had been exceeded, and stock option holders became afraid that if they did not sell, they would forego substantial profits.
A point had been reached when it simply not possible for domestic corporations to come up with enough buyback money to overcome the volume of new issues by foreign companies and the exercise of accumulated options by executives.
The reasons for the Great Bubble and the subsequent crash were generally not understood, and blame was directed to the usual suspects — speculators and a few bad apples among corporate managers.
The Common Stock Legend was still strong in the hearts of mutual fund investors.
Corporate buybacks escaped criticism as regulators were distracted by Enron, corporate accounting scandals, and illusions that 'independent directors' would somehow solve problems of corporate governance.
Instead, corporations continued their buyback programs, giving value to executive stock options, while mutual fund sales, although somewhat reduced in 2001 and 2002, were strong again in 2003.
However, although patterns of behavior continued, the proportions had changed. The ability of buybacks to drive the market forever upwards had been tested.
The market was now evolving to into a new configuration.
