Google has come out with a new service called Google Alerts that is a great tool for tracking the madness of the US equity market. Sign up and enter the words ’stock buybacks’ and each day your email will bring proof of the lack of market rationality.

Now, I’ve reported for some time (as many articles on this site attest) that buybacks have been driving the price of stock upward since the mid-1980s. Until the last year or so, however, most investors (as indicated by press reports) seemed unaware of this.

With Google Alerts, my email brings the news that things have changed:

• The fact that buybacks are forcing stock prices upwards is now widely known, accepted, and (mostly) applauded;

• The contention that price and value are equivalent has become conventional wisdom; an increase in stock prices due to buybacks is considered as boosting the intrinsic value of investors’ portfolios;

• The combined effect of private equity plays and buybacks reducing the supply of equities is considered a good thing and healthy for investors’ well-being.

A few years back, the fact that buybacks were driving the market had not yet become common knowledge —this has now changed.

But wait, my ‘Googlemeter’ brings more news:

• Corporations, in the aggregate, no longer have enough money to pay for stock buybacks out of cash reserves; they must borrow from banks to keep stock prices in the air. (This is confirmed by the Federal Reserve flow of funds accounts for the last year);

• Rating agencies (never fast to condemn doubtful practices) have begun to downgrade the bonds of companies that are financing buybacks with borrowed money;

• Banks are giving signals of reckless behavior (as they do from time to time, such as with margin lending in the 1920s, loans to Enron and Long Term Capital Management in the 1990s, and sub-prime lending recently) loaning money to finance buybacks — essentially giving depositors’ money (through the ruse of buybacks) to speculators who will never pay it back — and regulators, as usual, are unsure of what this all means.

Evidence that the investing public accepts this state of affairs is a sign that the market is in an advanced stage of its speculative fever, and that this, combined with indications that the market is over-priced in terms of dividend returns, portends that our patient will eventually swoon and fall to the ground.

The question is: when will this happen. (In other words, “Please daddy, can’t I stay in the market a little longer?”)

Waiting for someone to bite the tulip bulb

Folk tales of the speculative tulip mania in Holland in 1634-1637 circulate freely among Wall Street bears, along with the story of the (perhaps mythical) sailor who bit into a bulb, thinking it was an onion, thereby bringing reality to the market and crashing tulip prices.

Now, I have been working in capital markets for over two generations and have observed market psychology in booms and busts at first hand. I’ve also tried to warn clients in time to get out of dangerous markets in time and know by now that such warnings are generally unheeded.

The problem is that, although the signs of impending doom are there for all to see, no one can predict exactly when doomsday will come — tomorrow or two years from now —and investors want to hang on until the last possible moment.

I, for one, don’t know when the sailor will bite the tulip bulp.

The Look and Feel of the Top of the Market

Except in special circumstances, like the Crash of 1987, the end of a boom doesn’t usually happen on a single day. Here’s how the end will probably look and feel:

• On a certain day, prices will start down, perhaps sharply, but then recovering somewhat at the end of trading. The talking heads on Neil Cavuto’s show will scream at each other: it’s time to buy; stocks are now cheap. Neil himself will say calmly, “I have great faith in American businessmen and women.”

• The market will continue to back and fill, trending downwards. Investors will say, “Perhaps if the market gets back to the recent peak, I’ll sell a little.” The market probably won’t oblige, and, even if it does, investors will forget to sell.

• After the market has fallen considerably, say 20%, brokers will undertake a massive campaign to ‘reeducate’ investors, saying “We’ve now hit bottom”. Professors from Ivy League colleges will be hired to attest that stocks are indeed cheap, by all the laws of ‘economic science’. Wall Street will remind the public of how those who have held fast have always done better in the long run. Investors, never anxious to sell, will be convinced and will continue to see their portfolios erode.

In other words, the best time to get out of the market is right now — before the crash. Sure, you will miss some capital gains as the market continues to move upwards and your friends, still in the market, will look at you as a fool, but you’ll have converted already over-priced stocks into hard cash while it was still possible to do so.

It’s hard to sell now, while the party is still in full swing, but it will be even harder when the market crashes and you carry the psychological burden of actual losses.

But of course, few people will follow the course of prudence. That’s what speculative bubbles are all about.

If you are a long-term investor, holding your retirement nest egg in a diversified portfolio of US stocks, perhaps in an IRA or 401(k) plan, experts and the facts now suggest that your retirement assets are probably substantially over-valued in today’s stock market.

Many equity investors are not nearly as well off as they think — unless they are in the process of selling out today to invest in fixed income securities and a widely diversified portfolio of real estate income properties.

The question that long-term investors should be asking is how much do they risk losing by continuing to believe in the Common Stock Legend and the advice of their stockbrokers?

In the roar of Wall Street cheering about good times for equities, the chances that most equity holders will ask sensible questions about market values in time to save their assets is remote.

And, if and when they should ask, it will certainly be too late, because stock markets are not designed to withstand a rush for the exits.

Quantifying the downside risk in equities

It is possible to find serious researchers at prestigious universities and financial experts with articles in the Financial Analysts Journal that state that a fall of 30% to 50% from current market levels would be required for US equities to be ‘fairly priced’.

This means that that wealth held in US equities is probably over-valued by $3.3 trillion to $5.5 trillion! A readjustment to fair value would be painful, with serious economic and political consequences.

See: “Are GAO Projected Returns on Equities Reasonable?“

Most investors do not have the time, inclination, or skills to plow through the technical literature to find out whether stocks are over-priced. And the SEC will not help them.

However, investors do not need to rely on articles in Money magazine (supported by ads of Wall Street firms), or the Quicken ‘retirement planner’ (based on assumptions that the past predicts the future), or even on their stockbrokers (who earn a living by selling common stock and equity mutual funds).

By using common sense and some easily available statistics, John Burr Williams’ famous formula for equity valuation allows investors to check for themselves whether US equities, in general, are fairly priced or not.

As John Burr Williams pointed out seventy years ago, the sensible reason for long-term investors to hold common stocks is to receive a future stream of dividends paid by the company.

To build up wealth for their retirement, investors should put aside enough current income to provide for their old age, reinvesting dividends and interest received in the interim.

A prudent retirement plan: the essentials

No one can predict what the marketplace may be willing to pay for equities twenty or thirty years from now, when today’s retirees will need to sell investments.

However, with the anticipated crush of Baby Boomers needing money for assisted living and health care ten to twenty years from now, chances are good that ‘reinvesting unrealized capital gains’ in the hope of selling out many years from now is, at the very least, unwise.

A sound retirement portfolio is one that will throw off a dependable stream of cash dividends and interest, not only to provide income decades from now, but also to provide substantial current yields at that distant date so as to ensure that the value of a retirement portfolio is supported by cash payouts, so that, if it is necessary to draw down on the principal, the portfolio will be fully valued by the market.

Why US equities are 40% over-valued today

Here is how an investor might evaluate the level of US equity prices, based on John Burr Williams’ formula:

 

Input values of formula	Value
G= Dividend growth rate (based on S&P 500 dividends for period 1985-2006)	5.5%
I= Typical expected return for equity investments by American retirees	8.0%
John Burr Williams’ formula for evaluating one dollar of dividends	D/(I-G)
What current dividend yield should be, based on John Burr Williams’ formula	2.5%
Actual current dividend yield, based on S&P 500 (2006) stocks	1.77%
Market fall required to adjust S&P 500 current dividend yield to 2.5%	29.2%

See “The Value of Dividends” for an explanation of John Burr Williams’ formula.

 

In other words, given the S&P 500 rate of growth of dividends on US equities over the last twenty years, and popular expectations of return from long-term portfolios of common stocks (about 8%), equities, on average, seem to be over-priced by about 40% based on the current value of reasonable expectations of the future stream of dividends.

Considering that the annual growth of before tax US corporate profits over the long-term (1946-2003) was only 5.3%, predicting growth of corporate dividends at 5.5%, based on the S&P 500 dividends from 1985 to 2006, certainly does not seem to be overly-conservative.

So the two numbers needed for John Burr Williams’ equation, the 8% return expectation of investors and a 5.5% growth rate for dividends, seem to be quite reasonable.

Therefore, a drop of about 30% in stock prices would be required for equity investors to get the 8% return most expect when planning to fund retirement goals.

Corporate reform could dramatically improve equity values

Although, as indicated in the article “US Equities: Wildly Over-Priced or a Great Bargain?“, corporate earnings before buybacks are soaring to record levels, a huge multi-billion dollar chunk of this money is being diverted to the benefit of corporate executives rather than long-term shareholders.

If Corporate America were to suddenly reform, putting brakes on executive remuneration and redirecting buyback payouts into cash dividends, paid out fairly to all investors, then, indeed, Wall Street ballyhoo would be justified. Equities would be fairly valued and ordinary investors would be adequately protected.

However, since buybacks and corporate greed seem to be embedded in Wall Street culture, any investor who is willing to bet his or her retirement comfort on a sudden change of heart and sincere reform of rapacious executives, may deserve to be taken to the cleaners.

Expect continued irrational behavior

As pointed out in a previous article, if US corporations were to change their behavior, eliminating stock buybacks and using the money instead to pay dividends fairly to all shareholders, US equities would indeed by fairly priced and most retirement plans would be on track.

However, don’t hold your breath until that happens.

Uncontrolled, self-serving behavior of corporate executives taking advantage of an accommodating and dormant SEC and the unquestioning belief of the investing masses in the Common Stock Legend suggests that current patterns are likely to persist and that, therefore, US equities will continue to be substantially over-priced — until the next crash.

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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