One issue that is critical to understanding the U.S. equity market is to determine the degree to which profits from option-buyback programs are being reinvested in the stock market.

A superficial examination of the Federal Reserve national flow of funds tables might suggest that because equities held directly by individuals fell about $500 billion in 2005, while equities held indirectly through pension plans, mutual funds, and other intermediaries rose about $500 billion, that those who were selling stock were merely transferring their holdings to a more secure diversified format.

(See FOF Tables F100 and B100e)

However, a more careful examination of the data suggests that probably not more from ten to twenty percent of proceeds from the exercise of stock options were channeled back into the stock market. The money that balanced the equation by increasing indirect holdings of equities, came from salaries, wages, and government pension plans.

Gleaning the Flow of Funds Accounts

Studying the flow of funds accounts for 2005 together with information from the Investment Company Institute on the behavior of investors in U.S. equities in 2004, we get the following picture:

• Only 21% of Gross Investment by Households in 2005 was directed towards mutual funds, and only half of the money invested in mutual funds went into equities. Therefore, if the proceeds from the exercise of options were all invested and spread proportionately across the gamut of sectors (bank deposits, money market funds, real estate, etc.), only about 11% would have gone back into equities via mutual funds. (Tables F100 and F122)

• At least 40% of the net increase of indirect equity holdings by households, after adjusting for changes in market value, came from sources which seem highly unlikely to have any relationship to cash flows from the sale of stock options: government pension fund investments and investments in tax-deferred retirement plans, such as 401(k)s and IRAs. (See Tables F118c, F225i, and B100e.)

• The Investment Company Institute survey of U.S. shareholders in 2004, showed that 27% of those who sold equities either spent the money or invested in something other than mutual funds.

• Corporate buybacks in 2005 were 73% of net equity sales by households, suggesting clearly that the primary motivation for selling stock was not to reinvest in diversified portfolios of equities through mutual funds, but rather to take a profit from stock option programs.

Now, since those exercising stock options do not seem to have been reinvesting in equities, this would mean that the transfer of stock ownership from direct-holders to indirect-holders was financed by money coming from salaries, payrolls, and (in the case of public pension plans) taxes.

If Ordinary Investors Suddenly Become ‘Rational’: Watch Out!

The ‘Irrationality Axiom’ is one of the foundations of Capital Flow Analysis. This rule says that investors are not necessarily rational all the time.

But, from time to time, investors may suddenly have a ‘rationality attack’ and when this occurs, the effects on market prices can be impressive.

Here are some signs of the current climate of irrationality that are related to the non-reinvestment of option proceeds in the stock market:

• The people who sold stock options in 2005 were mainly insiders with a far greater appreciation of the future of the companies for which they work than the ordinary investor, holding stocks indirectly through mutual funds. The fact that these insiders failed to reinvest such significant amounts (hundreds of billions of dollars) in the stock market suggests that they have a less sanguine view of equities than the ordinary investor.

• Proponents of buybacks claim that stock repurchases are merely another form of dividends. However, in order to ‘collect’ these dividends, it is necessary to sell stock in proportion to the buyback. Since buybacks have become generalized, rational behavior of those holding stocks would be to sell in proportion to the buyback and not reinvest in the stock market. This suggests that, in addition to whatever their views regarding the future of their companies may be, option holders are just being rational by not reinvesting in the stock market.

• Ordinary investors, holding stocks indirectly through mutual funds and pension plans, are not selling equity positions in proportion to buybacks and putting the cash elsewhere, as ‘rational’ behavior would dictate. Instead, they are holding positions for the long term, while insiders are paying themselves special ‘dividends’ through buyback-option programs.

The total amount of U.S. equities that households held indirectly through pension and other funds in 2005 was $8.6 trillion.

The amounts of earnings distributed as ‘buyback dividends’ were 3.5% of total market value of equities.

In order for ordinary investors to receive their ‘buyback dividends’, they would have to sell 3.5% of their indirect holdings in equities and put the money elsewhere.

In other words, in order to receive their fair share of profits, these ordinary investors holding stocks indirectly through funds in 2005 would have had to sell $300 billion of these assets and have invested instead in bank deposits, money market funds, bonds, or real estate.

Without any doubt, such sudden ‘rational behavior’ would have crashed the stock market.

So, although Wall Street, in defending buybacks, says that they are just another form of dividends, if ordinary investors were to claim these dividends, there would suddenly be a lot of luxury homes for sale in the Hamptons.

This entry was posted on Wednesday, March 22nd, 2006 at 11:34 am and is filed under Equities, Corporate Managers, Individual Investors. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.

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