Federal Reserve Flow of Funds Accounts show that, at an annual rate, mutual fund net sales in Q3 2005 dropped to a nine year low. We must to go back to 1994 to find similar low levels of mutual fund sales.

In Q3 2005, government economists reported that Americans were spending more than they earned, "dissaving" at an annual rate of $132.9 billion ([1] NIPA income statistics).

Fund Investors: Shrewd Savers?

About 90 million people hold U.S. mutual fund shares, with a market value of $5.8 trillion, of which $4 trillion is represented by equities (Q3 2005).

Households are the principal investors in mutual fund shares. Those that buy equity funds put faith in the [2] Common Stock Legend — believing that systematic investment in stock funds is, in the long-run, the best way to preserve the family nest egg.

Over the decade 1995-2004, mutual funds have not been an extraordinary investment for the average holder. Although total assets of mutual funds in 1995 were $1.8 trillion, rising to $5.4 trillion by 2004, 60% of this increase was new money being invested, rather than returns on past savings.

On an annual basis, appreciation in the value of funds averaged about 3%, mostly in the form of paper profits. Management fees and administrative expenses ate up most income from dividends.

In December 1994, the SP 500 average price-earnings ratio was 16.9, compared to 18.9 in Q3 2005. If funds invested in equities ($3.6 trillion) were adjusted to the price-earnings ratio of December 1994, profits would be reduced by about 25%.

If equity funds were valued in terms of the historical average price-earnings ratio of 15, profits would be cut in half. Finally, if stock prices were to fall so that dividend yields were again equivalent to 120% of triple-A bond yields, as was the norm when Benjamin Graham was writing on security analysis, profits would be eliminated entirely.

(For a discussion of equity valuation, see the [3] Equity Value tutorial on this site.)

Fortunately for many, about 42% of money directed to mutual funds, on average over the years 1995-2004, was invested in bonds.

Fund Investors as Market Timers

Over the decade 1995-2004, 42% of new investment in mutual funds was in fixed income securities, and 58% was invested in equities.

From time to time, this allocation shifted, as investors tried to anticipate the market.

(See historical data for table F122 on the [4] Federal Reserve web site.)

In 2002, 83% of new fund money was directed into bonds before the stock market rally of 2003 and 2004, while in 2000, at the peak of the Great Bubble, 81% of new mutual fund investment was placed into equities.

In Q3 2005, 70% of new funds were channeled into stocks and 30% into fixed income, which indicates that fund investors hope stocks will rise in 2006.

This graph, based on Federal Reserve flow of funds data, shows how fund investments have been redirected from year to year over the last decade (US$ billions).

The Colossal Sell Out

Throughout the decade, as a group, households have been selling — not buying — equities. Individual investors, although loyal to stocks via mutual funds, were in Q3 2005 — as a class — net sellers of equities on a colossal scale.

In Q3 2005, individuals reduced direct holdings of equities by an astonishing $556.4 billion, while investing only $98.3 billion in mutual funds.

Since 70% of the amount invested in mutual funds went into equities, individuals sold, on balance, $457.7 billion in stocks. ($556.4-0.7*98.3).

Liquidation of equity holdings by individuals amounted to about 4.5% of total household income!

Net sale of equities by individuals of $457.7 billion was equivalent to 51% of net corporate profits in Q3 2005, before taxes, and 72% of after-tax corporate profits!

So what we have is individuals, as a economic sector, showing little interest in holding equities directly, while a sub-group of fund investors are still investing their savings in stocks via mutual funds. What is going on?

Why Stocks Go Up When Investors Are Selling

There is hardly any mystery as to why stock prices have been rising, although individuals have been liquidating their holdings at a fast rate.

The answer is found in [5] Flow of Funds table F102 (Nonfarm Nonfinancial Corporate Business).

Here we see that in Q3 2005, while households were selling a net $457.7 billion in stocks, corporations were buying back and retiring $446.2 billion of their own equities.

In other words, corporate cash reserves were flowing directly to stock investors who were selling out their holdings.

Where did these investor get over $400 billion in stock?

The answer is that corporations allowed them to buy stock at below market prices as part of regulated stock option plans.

In order to make sure that these options were valuable, executives used company cash, which in principle should belong to permanent investors, to buy stocks on the exchange at ever higher prices.

This is a continuation of the buyback-options scheme that has been depleting assets of naïve fund holders for a generation.

(For a full explanation, read the essay: [6] The Great Misleading, and related articles on this site).

The difference now, however, is that the scale of buyback have begun to exceed all reasonable bounds.

Business Week Blows a Timid Whistle on Buybacks

After a long silence about the morality of buybacks, there some signs that market opinion may be changing.

On January 23, 2006, Business Week published an article promising to reveal the "[7] Dirty Little Secret About Buybacks". http://www.businessweek.info/magazine/content/06_04/b3968099.htm

In this article, Merrill Lynch analyst Joseph Osha is quoted as saying that stock buybacks are little more than "backdoor compensation" for employees. Osha is also reported as stating that, compared to dividends, "buybacks don’t represent the same long-term commitment of returning wealth to shareholders"

However, this is still a long ways from general admission by the financial community regarding the true nature of the buyback-option schemes.

For example, the Business Week article still endorsed buybacks, saying, "The logic of buybacks is sound".

When I first began to write about buybacks in 1999, almost no negative opinions regarding the practice could be found on the Internet. Now, searching Google for ‘buybacks’ and you can find quite a few writers who are skeptical about the practice, although the mainstream media is still defends such programs.

Why Fund Managers Love Buybacks

The Business Week article quotes Bill Miller, portfolio manager of Legg Mason Value Trust, as defending a large buyback by Dell, saying "Their stock is cheap, and they’re putting their cash where its worth more."

Now, presumably, Bill Miller, a Chartered Financial Analyst who has managed funds that outperformed the S&P 500 index for 13 years, knows that buybacks are not a corporate investment at all, but only a way to transfer corporate funds to a few shareholders.

His suggestion that Dell’s cash is "worth more" in the bank accounts of option holders than as dividends to long-term shareholders, seems ironic.

However, Bill Miller and other managers of mega mutual fund groups, control the proxies that elect the directors that approve stock buybacks.

Postings on the Internet suggests that Miller fully understands the link between stock buybacks and rising stock prices.

In a letter to shareholders in 2004, Miller said, "I am quite optimistic about 2005. … I would expect corporate share buybacks to accelerate … lots of excess cash is available to be used for shareholders [sic] benefit."

Stock buybacks are nothing more that legalized market manipulation, whereby fund managers and corporate executives exploit a "safe harbor" provision of the SEC rules to the detriment of long-term shareholders.

A savvy fund manager, like Bill Miller, who is in a position to know which large buybacks will jack up stock prices, can position a portfolio so as to be long on stocks during the ‘mark up’ phase of the manipulation, thereby continuing to beat the S&P 500 as long as corporate buybacks rule the market.

(See the article on "[8] The Boeing Buyback").

Never Have So Few Fleeced So Many for So Long

According to the National Compensation Survey of March 2003, 8% of employees participate in some sort of stock option plan.

This suggest that as many as eight million employees may own stock options.

However, most employee option plans are for modest amounts, with substantial restrictions on cashing in. The really juicy options, the ones worth millions to the beneficiaries, are reserved for top executives and corporate insiders.

No one seems to know for sure how many are involved in the most lucrative class of option plans that account for the over $450 billion annual rate of buybacks in Q3 2005, but a reasonable guess would be not more than 10% of employees with options are in this inner circle.

That would mean that there are about 800,000 fortunate souls with option plans worth perhaps six figures. Considering that there are 90 million holders of mutual fund shares, for every one hundred mutual fund shareholders, there is probably one option holder receiving substantial chunks of corporate cash that would otherwise belong to ordinary shareholders.

The by-product of stock buybacks is a temporary increase in the price of stocks, which is reflected in published mutual fund ‘performance’ figures, which treat unrealized capital gains as real returns. This published ‘performance’ serves to lure investors to funds with the greatest short-term paper profits.

The groups supporting buybacks are powerful, articulate, well-financed, and motivated to maintain the status quo. They have kept the buyback machine running for twenty years.

Cracks in the Buyback Façade

If buybacks were to suddenly stop, the U.S. stock market would enter a new era, the first effect of which would most likely be a sharp drop in prices, as values adjust to historical levels.

The end of the buyback era would not be pretty to see.

Millions of Americans would suddenly be poorer than they imagined.

Therefore, the pressure to continue buybacks is tremendous.

Nevertheless, the scheme has weaknesses that are likely to eventually bring the system down:

1. To keep stock prices continually rising takes every larger amounts of cash spent on buybacks. Eventually corporations will run out of money and the scheme will fail.

2. The solid wall of supporters in the financial media, with pecuniary interests as recipients of advertising revenues, stock commissions, fund management fees, or as option holders, will eventually be breached by the ‘free press’ of the Internet and by the sheer number of fund shareholders that are being misled. (You can’t fool all of the people, all of the time.)

3. The coming retirement of [9] Baby Boomers, with consequent liquidation and repositioning of mutual fund portfolios, will put pressure on equities, giving rise to questions about buybacks and options.

The Business Week article, mentioned above, is perhaps an early sign of skepticism about buybacks in mainstream media. The extraordinary level of buybacks in Q3 2005, is another sign of strains on the system.

Of more interest still is how the extreme level of buybacks has caused the NIPA figures on personal savings to be severely distorted, making Americans appear as spendthrifts. (Economists calculate ’savings’ without considering capital gains, which is a problem when stock options worth hundreds of billions of dollars substitute dividends.)