The S&P500 index rose 2.8% in Q3 2005, manipulated upwards by highly motivated corporate executives intent on using stock buybacks to enhance market ‘performance’ and cash in on stock options — before SEC rules requiring greater disclosure of management remuneration become effective in 2006. (Federal Reserve Flow of Funds Table F213)

Stock buybacks by non-financial domestic corporations reached a record annual rate of $446.2 billion in Q3 2005. This was 3.7 times the level of buybacks in the year 2000, the peak of the Great Bubble, and double the level of the previous record in 1998 — a year in which the S&P500 index rose 25%.

As I observed elsewhere, it seems to take more and more buyback cash to push prices upwards as the market expands.

(See: “Flows in Context“)

If $446.2 billion in annual flows jacked up prices only 2.8% in Q3 2005, compared to $215.5 billion pushing prices up by 25% in 1998, the buyback dollar seems to be losing its punch.

In fact, capital flow patterns in the equity market in Q3 2005 appear eerily similar to those of 2000, the year during which the Great Bubble popped. (See the graphs, below)

Is the 1990s Bubble Still Imploding?

For many on Wall Street, for whom two or three years is the ‘long-term’, it may seem that the equity market entered a new bull market in January 2003.

However, from the point of view of Capital Flow Analysis, there is no sign that the forces driving the Great Bubble, which began in the 1980s and peaked in August 2000, were exorcised at all by the Crash of 2001-2002.

Despite the publicity surrounding the Enron trial, the auto-de-fe of Arthur Andersen, the Sarbanes-Oxley Act, the mob-pleasing, but irrelevant incarceration of Martha Stewart, and FASB Statement 123 on Share-Based Payment, there is no indication of a sea-change in the thinking of corporate executives or mutual fund investors.

The asset-lite movement, buyback-option schemes, and the Common Stock Legend are still alive and kicking.

From a sociological view of markets — familiar to capital flow analysts— we are still on the down slope of the imploding Bubble of the 1990s.

Therefore, it is useful to review the flow of funds data for corporate equities in Q3 2005 in the light of the persistent behavior of major market players.

What Are Persistent Stock Buyers Doing?

Four sectors, who were persistent buyers of equities during the Great Bubble of the 1990s, have continued to play the same role and exhibit the same motivation since stock prices turned downwards in mid-2000.

1. Domestic Non-financial Corporations: For many years, this sector has been a consistent buyer of equities — reducing market supply and driving up prices, as company executives manipulate ‘performance’ and give value to their stock options.

2. Mutual Fund Investors: Unsophisticated individuals, ardent believers in the Common Stock Legend, enticed by the fiscal benefits of 401(k) plans and IRAs, have entrusted long-term savings to managers of equity mutual funds. The dubious ‘performance’ figures of ‘total return’ with unrealized paper profits have overcome skepticism and commonsense.

3. Foreign Investors: Portfolio investment from overseas has, for many years, tended to increase as the equity market reached peaks, to fall back when prices fell — suggesting that foreigners play the patsies in the U.S. equity market.

4. Life Insurance Companies (net): These institutional investors are persistent buyers of equities, both as issuers repurchasing their own stock and as portfolio investors.

The graph shows how stock purchases from these sectors have fluctuated over the decade. Note the build-up until the peak of 2000, followed by a fall back during the Crash of 2001-2002.

With the market recovery in 2003, although price levels of the 2000 top were not attained, substantial motivated buying again drove prices, especially in Q3 2005.

The increase in buying by foreign investors in 2000 seems to have been repeated in 2005. This may be a portent of an impending reversal in 2006 or 2007.

Which Sectors Have Been Selling Stock?

Three sectors have been consistent sellers during the Great Bubble and thereafter.

1. Households: Individuals, mainly holders of stock options, are primary sellers in the U.S. equity market. In 2000, when it appeared that buybacks could no longer support stock prices, individuals rushed to sell before it was too late; thereby pricking the Bubble and inviting the Crash of 2001-2002.

2. Foreign Corporations: Unlike domestic companies, foreign corporations tend to view high price-earnings ratios as a selling opportunity, taking advantage of low capital costs. In 1999 and 2000, issues by foreign corporations were large enough to overcome the market support of domestic buybacks.

3. Private Pension Funds: Traditional sophisticated long-term investors, private pension funds as perennial net sellers of equities, seem to affirm the notion that equities are over-valued.

The graph shows the build up of selling pressure from these groups over the period 2002 to 2005, mirroring similar behavior as before the Bubble peaked in August 2000.

Because of costs associated with the Sarbanes-Oxley Act, foreign corporations have shown interest in withdrawing from the U.S. market. However, the SEC has indicated willingness to excuse foreign corporations from certain provisions, in the hope that foreign issuers will continue to be active in the U.S. market.

There is a certain irony in this, since foreign corporations have acted as a countervailing force to domestic buybacks, thereby exerting downward pressure on stock prices.

What We Have To Look For in 2006

The similarity of capital flow patterns in 2005 and 2000 does not bode well for equity prices in 2006 and beyond. In historical terms, stocks are already over-valued and therefore any increase in motivation on the part of the major selling sectors, particularly households, could crash the market.

(See the tutorial on equity values on this site.)

There are a number of developing stories that seem inauspicious for equity prices:

1. Executive remuneration. Although FASB 123 falls far short of revealing the true cost of buybacks and options, the Business Week January 23, 2020 article, promising to reveal the “Dirty Little Secret About Buybacks“, suggests that perceptions may be changing. If the truth about stock options and buybacks comes to be generally accepted (which is not the case today), the Bubble of the 1990s will be finally over.

2. General Motors and Ford. Hard times are likely ahead for employees, retirees, and shareholders of General Motors and Ford, as the cost of decades of self-indulgent, over-paid executives pandering to labor unions for short-term advantages, becomes apparent. A wider understanding of the costs of pension plans and buyback-option schemes should undermine those Bubble practices that continued after 2000. The fate of individual companies ordinarily has little effect on capital flows, but, in the case of these automotive giants, symbolic importance may generate publicity that changes how people think.

3. Foreign Issuers. A desire to have Wall Street retain its positions as the leading international financial center, combined with the rational views of foreign executives that regard the stock market as a source of long-term funding, appropriate to being tapped when price-earnings ratios are high, while keeping executive remuneration within bounds, will likely lead in preferential treatment of foreign issuers who are already more apt to sell stocks to raise funds than their domestic counterparts.

4. Declining Dividends and Profits. The unfortunate practice of domestic companies slashing dividends in 2005, in favor of buybacks, plus the possibility that the cost of buyback-option schemes may finally be understood, could drastically reduce the perception of the value of U.S. equities at a time when Baby Boomers are becoming wary of the safety of their retirement funds.

The comment by Joseph Osha, analyst of Merrill Lynch, who in the Business Week article, above, said that buybacks were little more than “backdoor compensation” for employees — an opinion that I share — means that buybacks should not be viewed as a form of dividends, but rather as an expense to be deducted from after-tax profits when evaluating the performance of domestic corporations.

This argument is reinforced by the fact that, despite two decades of buybacks, the total number of shares outstanding have not been reduced. Instead, new options are issued to take the place of stock that has been repurchased, and the game goes on.

If we adjust after-tax profits of non-financial corporate business for the ‘cost’ of buybacks over the last decade, here is the picture that emerges:

I have been around capital markets long enough to realize that this chart is subversive and possibly may attract unpleasant comment and quibbles of varying importance from authorities and experts.

Almost no one will want to accept this view, and those who may be shaky in their own mind will feel the need to run to a market professional who will quickly assure them that the concept is rubbish.

Furthermore, I am also aware that, by the rules of accounting, buybacks are supposed to be deducted from capital, not income. However, here we are talking commonsense, not accounting practices.

‘Real Profits’ Are Concealed

The logic is simple. If buybacks do not go to all shareholders, but are designed to remunerate only certain employees and executives, then, from the point of view of long-term shareholders who never see a penny of this money, buybacks must be considered an expense and should be deducted from income.

The blue line for ‘adjusted’ after-tax corporate profits suggests that there has been no real improvement in corporate profits for over a decade.

If inflation were considered, the profit trend would be downwards. With dividends cut in 2005 to make room for more buybacks, the utility of equities as a long-term investment is diminished.

What all this suggests is that in approaching the equity market in 2006 or 2007, it would be prudent to have one’s feet planted so as to be able to execute a quick retreat.

Although this is an unpleasant thought, not likely to attract stockbrokers to advertise on this site, prudence may be preferable than following the crowd, when your nest egg is at risk.

This entry was posted on Monday, January 23rd, 2006 at 3:26 pm and is filed under Equities. 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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