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.

Private equity firms now control about 7% of U.S. corporate equity, or $800 billion, according to estimates of Thomson Venture Economics and quoted in the BusinessWeek cover story, “Going Private”, of February 27, 2006.

Private equity firms gather capital from the Super-Rich in order to take firms private and to concentrate on long-term goals, escaping over- and misguided- regulation by the SEC and the provisions of the Sarbanes-Oxley Act.

Since the Super-Rich own 47% of U.S. household financial assets and hold about one-third of this in equities (1997 estimates), $800 billion invested in private-equity ventures would amount to about 14% of their stock holdings — a substantial portion!

(See: “Rich and Poor“)

Private-equity ventures seem smart, compared to investments in ‘hedge funds’, which are often little more than flimflam deals, in which investors hand over cash, no-questions-asked, agreeing to pay 25% of profits, with no penalty for loss, to operators of essentially blind trusts, which, in recent years, have produced, on average, very mediocre results.

In contrast, partners of private-equity ventures typically receive 1.5% as an administration fee and 20% of the profits only when a venture is taken public or is sold.

The most attractive aspect of such arrangements is that, at least during the phase in which companies are privately-held, management does not need to focus on quarterly results or the burdensome reporting to government regulators, while the negative aspects of the buyback-options schemes that now dominate public equity markets are avoided.

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It is fashionable in some quarters to say that it doesn’t make much difference who wins the elections; the country will go on its own way without much change.

However, in 2004 this is probably not the case.

In several areas it may be important whether Bush or Kerry becomes the next president:

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