The Federal Reserve Flow of Funds Accounts for Q2 2009 showed a positive net issuance of Non-farm Non-financial Corporate Equities at an annual rate of $88 billion (Table F.102).

At the same time, cash dividends of this sector fell 22.5%, from the annual rate of $465.8 billion in 2006, to only $360.7 billion in Q2 2009.

This is a reversal of behavior observed until Q1 2009, when it seemed that the Stock Buyback Era might not be dead, after all.

See: “Stock buybacks refusing to die … live on!”

This is the first significant statistical indication that the stock buyback era may indeed by over.

What it will take before the “stock buyback death certificate” can be issued

The stock buyback era started in 1982 with SEC Rule 10b-18 that gave safe harbor to corporate executives to use equity repurchases to fraudulently manipulate stock prices upwards to give value to their stock options.

The US Security and Exchange Commission has not yet revoked Rule 10b-18, but it has published a Q&A page on its web site indicating that it seems to be at least vaguely aware of the unfair impact of this rule on ordinary investors.

There is far more criticism of stock buybacks today, than ten years ago.

However, public opinion is still far from rejecting the practice as being clearly fraudulent.

See: Stock Buybacks — A Fable

Academic support for stock buybacks is still strong and MBA candidates are not yet being taught that the practice is unethical.

See: New York Times: Are Buyback Stocks Still Good for Investors? . This article discusses yet another academic pseudo-scientific apology for stock buybacks.

The permanent demise of stock buybacks will ultimately depend upon investors switching their attention from the false promise of “total returns” (which includes non-realized capital gains) to the solid comfort of cash-in-the-bank “dividend yields”.

No one knows for sure the real earnings of American corporations.

In Q1 2009, according to the Federal Reserve flow of funds table F.102, after-tax profits of US non-financial, non-farm corporations, on an annual basis, were about $589.9 billion.

However, about 50% of these after-tax earnings were disbursed through stock buybacks, primarily to support prices and give value to executive options. See: Stock buybacks refusing to die live on!

The “cost” of employee stock options, according to FAS Rule 123 of March 2004 must be “disclosed but not recognized” by issuers in their financial reports.

There is no easy way of knowing whether or by how much the earnings behind S&P price-earnings-per-share figures have been adjusted for executive stock options.

However, it is certain that, whatever the adjustment, it is far less than the cost to long-term shareholders in terms of cash no longer available for dividends or corporate reinvestment.

	Investor monkeys contemplating the unknown

FAS Rule 123 vastly understates the real cost of stock options

Ever since 1982 when the US Securities and Exchange Commission granted “safe harbor” to corporations using stock buybacks to manipulate prices in order to give value to executive stock options, a increasing portion of corporate earnings have been diverted from dividends that would benefit ordinary shareholders to stock buybacks for the benefit of corporate executives.

While accountants argue technicalities as to whether the Black-Scholes model or the Binomial model best represents the “cost” of executive options that should be disclosed, the fact is that the true cost to shareholders is far greater than the actual benefit to executives, since it takes more money to manipulate prices upwards by using buybacks than executives actually receive as profits when exercising their options.

In other words, the buyback fraud lives on. See: The Great Misleading.

Money for dividends that would benefit long-term shareholders is diverted for manipulative purposes and is not registered as a cost at all, but, according to Generally Accepted Accounting Practices, is posted directly to the capital accounts of the company.

If buybacks were only a tiny portion of the market — as was the case in, say, 1980 — we might ignore this accounting foible.

However, in Q1 2009, despite the shortage of credit and the need to conserve cash to get through hard times, corporate executives, in general, supported by subservient boards of directors, continue to recklessly misuse stock holders funds to support prices for their own benefit through the use of buybacks. See: Stock Buybacks: A Simple Fable.

And the US SEC commissioners continue to avert their gaze from this shameful practice.

Is the real S&P 500 price-earnings ratio 18 or 36? — no one knows

If the S&P 500 PE ratio was 18, as now appears in the newspapers, one might conclude that stocks, although over-priced, were still a reasonable investment.

However, if the real PE ratio was closer to 36 — but hidden by the loopholes in GAAP, the current market “recovery” would appear to be a mere bounce in a bear market heading for further losses.

It would seem that it is a little early to break out the champagne and to start celebrating economic recovery.

In the working paper “The Buyback Monitor - July 2009: Corporate Stock Buyback Profits of 273 Firms from 2000 into 2009“, published on the Social Sciences Research Network, M.A. Gumport, CFA, provides further evidence that stock buybacks are not as good for investors as often touted.

The following is quoted from the abstract of this research paper:

Few purely financial decisions rival stock repurchase programs in their bearing on the well-being of shareholders. Absent better financial reports on buybacks, an occasional tally of results seems appropriate. The current “Monitor” extends an earlier study back to 2000 to look at profitability of $263 billion of buybacks executed by a sample of 273 corporations, largely in the technology sector, with total equity market value of $655 billion. 66% of sampled companies engaged in buybacks. While this studies’ reporting methodology tends to significantly overstate buyback profitability, only 25% of buyback programs are currently reported to be profitable.

The average sampled company that engaged in buybacks paid out 43% of its current equity market value to buy shares that subsequently declined in value by 19.7%. Had buybacks not been executed, share prices for these companies now would be at least 8.4% higher (or, after adjustment for bias in methodology, more than 13% higher).

Buybacks are undesirable corporate behavior

This study provides evidence on the company level that stock buybacks — exempted from normal legal sanctions for stock manipulation since 1983 by SEC Rule Rule 10b-18 — are not as beneficial to investors seeking short-term capital gains as usually claimed.

The proponents of stock buybacks have long argued that capital gains are better for investor than dividends. Without stock buybacks, cash dividends could have been much higher over the last generation, which would have contributed far more to investor wealth than unrealized, fleeting capital gains.

Until the 1960s, dividend yields on US equities usually surpassed bond yields. From the 1980s onwards, capital gains became the goal and dividends faded in importance.

In the article section, The Wisdom of Dividends, there is an analysis showing that over the long run, if the former practice of favoring dividends over capital gains had persisted over the last three generations, investors would be much better off today.

However, the SEC continues to sanction and encourage equity buybacks, and to allow misleading total return statistics to distort mutual fund reporting. The government imposes double taxation on cash dividends and the Obama administration is proposing even higher taxation of dividends in order to pay for various “spending is stimulus” programs and nationalized healthcare.

M.A. Gumport’s recent research paper on the effect of buybacks on stock prices contributes to the growing body of evidence against stock buybacks that, eventually, may influence government policy and investor opinion.