On September 17, 2020, Capital Flow Watch called the top of the Buyback Bubble, issuing a warning that stock prices might be in for a sharp fall. Unfortunately, that comment turned out to be correct.

The outlook considered two simple facts:

• Stock prices are supported by equity buybacks, which, in turn, now depend upon loans for funding.
• The sub-prime mortgage event that started in July 2007 and the ensuing credit crunch, reduced money available for buybacks, weakening a support of equity prices.

This forecast was based on long-term trends concerning buybacks and equities, not on current numbers — the Federal Reserve publishes flow of fund accounts with a three month lag.

Now that we have the figures for Q3 2007, its possible to further access the situation and look forward.

US corporations are running out of buyback money

Federal Reserve flow of funds table F.102 (Nonfarm Nonfinancial Corporate Business) shows that in Q3 2007, corporate profits after taxes and dividends were at an annual rate of $232.1 billion. However, corporations were buying back their own stock at an annual rate of $446.8 billion.

Buybacks are no longer just “another form of dividends” as management has often claimed, suggesting profits as the source of funds. Rather, buybacks are now financed out of depreciation reserves, and most importantly, from borrowings. They are, in large part, a return of capital — mostly to people who never put up capital in the first place.

During 2007, credit rating agencies (often the last to spot danger), awoke to the risk of equity repurchases and began down-grading corporations that used debt to finance buybacks. Despite this, the buyback frenzy continues.

Moreover, in Q3 2007 something extraordinary happened: US corporations began to borrow abroad — in huge amounts. Because money is fungible, much of this went into stock buybacks.

In Q3 2007, the net increase in corporate borrowing from the “Rest of the World” was $232.7 billion, compared to annual rates that were often negative and never exceeded $28.3 billion from 2003 to 2006.

It takes ever greater amounts to keep stocks rising with buyback cash.

The flow of funds accounts reveal a grim picture. To give value to their stock options, executives, as a group, cut dividends to shareholders, diverted funds from depreciation reserves, issued bonds, even risking a fall in credit ratings, and , scraping the bottom of the barrel, so to speak, accelerated borrowing from aboard.

For equities, buybacks are the only game in town

Capital Flow Analysis is based on the premise that stock prices are not driven by earnings ratios, financial statistics, or “instrinsic value” (whatever that is), but rather by the raw force of motivated buyers facing more or less motivated sellers, as measured by the amount of money each party brings to the table.

In the equity market in Q3 2007, the principal buyers were (net flows, annualized):

Equity buyers Q3 2007, annualized

US nonfarm nonfinancial corporations (buybacks)	$846.0 billion
Insurance companies	$94.1 billion
Mutual funds	$58.0 billion
Closed-end funds	$31.5 billion

On the buying side, most money comes from buybacks.

Mutual fund net purchases of $58 billion (often representing automatic investment through 401(k) plans and IRAs), is way down from comparable figures of between $129.6 and $158.5 billion from 2003 to 2006.

On the selling side, comparable figures are:

Equity sellers Q3 2007, annualized

Households	$563.0 billion
Foreign equity issuers	$192.8 billion
Pension, retirement funds	$125.5 billion
Broker dealers	$52.7 billion

The motivation of the sellers is not hard to divine:

• foreign issuers are raising money in an equity market where capital is cheap;
• pensions, retirement funds, and broker-dealers are sophisticated players, selling because stocks are over-valued.

The motivation of the “households” category is also not mysterious.

This is a behavior that has persisted for a generation. Most household net selling represents corporate executives (and perhaps hedge funds going along for the ride) cashing out stock options.

The same guys on both sides of the market

So here we have the equity market in a nutshell.

On the buying side there are corporate executives ordering buybacks, using money that rightfully belongs to shareholders.

On the selling side we also have corporate executives exercising options and cashing in on buybacks they ordered.

Is this fair? Is this even a real market? Could there perhaps be a greater conflict of interest? What are the odds that corporate executives (wearing their executive hats) will overlook their greed and remember their fiduciary duty to shareholders?

No, no, no, and none.

Why ignorance is not bliss

As long as Wall Street and the Federal Reserve think that tinkering with short term interest rates will save the equity market, ignoring the effect of buybacks on equity prices and the motivation that drives the market, there is little chance that the outlook for equities will improve.

Here is why:

A corporate executive, once he or she reaches the pinnacle of power with a hand on the buyback lever, knows that this is a last and only chance to feed at a trough that has enriched so many for over a generation. If Wall Street is applauding buybacks and if shareholders don’t know any better, why not keep on feeding? Morality, after all, is based on common perception. No one has ever gone to jail for cheating investors through buyback schemes.

The SEC doesn’t care and even approves. The Federal Reserve says nothing and seems ignorant. Candidates of both political parties keep mum. Neil Cavuto, Lou Dobbs, and the Wall Street Journal have no comment. Fund managers and Wall Street analysts cheer each decision to increase buybacks. It is as if the Federal Reserve flow of funds accounts didn’t exist.

But buybacks are not free nor without consequences. They cost corporations their reserves against hard times, funds for long-term investment, and financial stability. This, of course, won’t stop executives who weigh cash in their own pockets today against the welfare of distant, almost mythical shareholders at some future date — when, as Keynes said, we all will be dead.

By weakening companies and eroding shareholder trust, a disservice is done to the system and to future generations, as corporate savings are diverted to non-productive ends. But never mind.

Even as stock prices fall, executives can find ways to readjust the value of their options downwards — after all, without stock options how could corporations attract “the best talent”?

So the only real brake on stock buybacks is how much money corporate executives can scrape from profits, reserves, dividends, and unwary lenders.

Sophisticated investors look elsewhere

From the Q3 2007 figures, we see that sophisticated investors and even mutual fund savers, are moving away from equities. As baby boomers being to retire and switch from equities to bonds, mutual fund interest in equities will decrease.

The credit crunch is certainly not over; big banks are being chastised for their profligate ways.

The rating agencies are onto the game.

Sooner or later the money for buybacks will dry up, but meanwhile, the market continues to fall as executives becoming more and more excited at the last chance to cash out their options.

An improbable solution

There is, of course, a way to stop all this.

The SEC, the Federal Reserve, and the political leaders would have to come together and condemn buybacks, insisting instead that if executives are to be rewarded for “performance” it should come through dividends paid to stocks that they, like everyone else, have paid for in full. After all, if this was good enough for Andrew Carnegie, why not for modern would-be moguls?

If this happened, cash dividends would shoot upwards. Stock would become worthwhile investments, based on dividend yields that, like in olden times, would surpass bond yields. Dividend yields would brake falling prices. Executives would be motivated to invest in the future and increase dividends. It sounds just like capitalism!

However, fat chance! Don’t count on it.
There are thousands and thousands of corporate executives, fund managers, and broker-dealers that know nothing else than the buyback culture. These people are not going away and have a lot of money to fight reform.

As for the economy saving the stock market, in the best of circumstances, it will take time to mend the banking system. A harder look at big loans for foolish purposes by weakened banks, will not help corporations anxious for funds to buy back stocks from their own executives.

With recession at hand, the American political outlook offers a return of the Clintons (with higher taxes and increased government regulation) or of someone like Mitt Romney, a former corporate executive, who has said that in the first crisis he would call in McKinsey & Company, the consultants to Enron.

Of course, there are good investments still out there, even among equities, and there will be even more as the recession deepens, but here we’re examining the immediate direction of the stock market, based on flow of funds analysis.

It is always somewhat foolish to attempt to call the top of a bull market or the precise moment when a speculative bubble pops, but sometimes its better to be foolish than sorry.

During the ides of July 2007, when the Dow Jones Industrial Average was gently massaging 14,000, signs appeared that air was finally beginning to leak out of the Great Buyback Bubble that has long characterized the US equity market.

The headlines were about a liquidity crunch, sub-prime lending, and banking risk, but the buyback band kept on playing, as if these events were in some parallel universe and that Mr. Increased Earnings Per Share, Ms. High Employment, and General Good Times were in charge and would keep equities moving up, no matter what.

However, from the point of view of flow of funds analysis, the ides of July 2007 brought bad news indeed for the equity market.

Why the July 2006 Credit Crunch Bodes Ill for Equities

The forces driving the market upwards have been more than evident for some time:

• Corporations have been aggressively forcing stock prices upwards by spending trillions in earnings, depreciation reserves, and borrowed funds on equity buybacks. Their motives have been simple and clear: companies need to win the approval of fund managers who control executive remuneration and bonuses and who are only interested in one thing: short-term stock price appreciation. The only way to guarantee that fund managers will be happy is to use buybacks to manipulate prices upwards.

• Individual shareholders have been vigorously selling holdings of equities, mainly to cash in executive stock options while prices are still high. For over a generation, individual direct sales of equities have exceeded purchases by a wide margin (now more than one trillion dollars every year and a half).

• Mutual fund holders, mostly ignorant of how markets really work, have continued to invest merrily in equities, hypnotized by SEC-approved Total Return figures (inflated by unrealized capital gains driven by massive buyback programs) and mutual fund marketing ballyhoo, unaware that buyback money is not going to them, the real owners of corporate America, but to executives, fund managers, and speculators.

The excess of buybacks over new issues now surpasses one trillion dollars every eighteen months — an astounding figure crushing all past records.

A Massive Ponzi Scheme

The dirty little secret about buybacks is that they are the essential element in a massive Ponzi scheme that favors corporate executives and fund managers.

As stock prices rise, it takes ever more money to drive prices even higher. When prices rise faster than the long-term rate of increase of corporate earnings per share (only about 5.1%), it gets harder and harder for companies to keep prices going up.

To raise money for buybacks, dividends must be cut, earnings depleted, depreciation and maintenance reserves forgotten, and “investing for the future” thrown aside. Even so, sooner or later the money simply runs out, the band stops playing, and equity prices fall.

For over a year, a large portion of buyback money has come from bank financing — a really stupid way for bank credit officers to apply depositor’s money.

The Liquidity Crunch

The significance of July 2007 to the Buyback Bubble was the sharp and sudden decrease in worldwide financial liquidity — which doesn’t mean that money disappeared — only that credit officers and investors suddenly began to come to their senses and realize the error of their ways.

After all, lending money to people without a job to buy real estate with no down payment at inflated prices is a far cry from rational lending practices.

Now bank credit officers are like any other pack of animals — they run the same way at the same time and are easily spooked. At the current extreme rate of buybacks, so dependent upon borrowing, any cut in buyback financing or glimmer of rational lending practices is really bad news for the equity market.

So the liquidity panic of July 2007 with its probable lingering consequences on credit policy, is the main reason to say that the Buyback Bubble has popped — perhaps not explosively, but decisively pricked nevertheless.

As companies find it more difficult to finance buybacks, executive option holders will be highly motivated to cash in their unrealized profits, as fast as possible, while there is still time. The volume of options held is so great, that any increase in selling will easily drive stock prices lower. As prices fall, more executives will have incentives to exercise options.

Joining them in the rush for the exit will be hedge fund managers, who have been going along for the ride and will note the end of the buyback bubble well before the unsophisticated masses holding mutual funds.

Finally, as prices fall far enough, mutual fund total return figures will become ever less attractive. Baby boomers approaching retirement will awake to the fact that you can’t live high on the meager dividends equities now pay; the rush to fixed income will begin. This will accelerate as interest rates rise.

Waiting for Hillary

While this rather glum background music is playing, we have to pass through the highly toxic atmosphere of US presidential politics.

Unless some miracle happens, it now looks like the next US president will be Mrs. Hillary Clinton, reigning with control of both houses of Congress.

Judging from what Mrs. Clinton has already promised her constituencies, here is what it would be reasonable to expect from her administration:

An increase in protectionist measures: This would tend to reduce the trade deficit, cutting the principal supply of easy money to US borrowers, sending up interest rates. The reduction in cheap imports from China and elsewhere will also drive up prices, tricking the Federal Reserve into raising interest rates to “fight inflation”. Higher interest rates will remove cheap financing for buybacks and drive stock prices down.

An increase in income taxes: Massive increased coverage for public health care, along with the need to repay campaign promises with increased government spending, will mean higher taxes and less money for consumers. This means lower corporate profits and less money for buybacks.

So, even if we lay aside the consequences of losing the War on Terror (seemingly, an almost certain consequence of a Clinton victory), there seems to be little reason to be optimistic about the outlook for the stock market.

Think 1973. Think Jimmy Carter!

Depending upon your point of view, the US stock market is either vastly over-priced, or a great bargain — and if you have a split personality, you could both be right!

This peculiar state of affairs occurs because two radically different yardsticks can be applied in measuring corporate performance: one based on an unquestioning respect for Generally Accepted Accounting Principles, and the other based on commonsense, an appreciation for cash in hand, and the time-honored principle of “what’s in it for me?”.

The key to this conundrum lies in how one views stock buybacks: Are the trillions spent on buybacks really the money of most common shareholders, or do they belong to someone else?

• If you are a long-term, buy-and-hold investor, with a portfolio made up mainly of index funds and equity mutual funds, the money that goes into stock buybacks is definitely not yours. It goes to someone else. You’ll never see a penny of it!
• If, however, you are a corporate executive with loads of stock options, or with remuneration linked to stock prices, or if you are an equity hedge-fund manager, with 20% of the profits on borrowed money and somebody else’s nickel, with no downside risk (for you), then stock buybacks are definitely to your advantage.

If you believe that GAAP profits tell the whole story, then perhaps equities are really a bargain. Don’t worry, be happy.

However, if you’re a tiny bit skeptical and are willing to look at profits with a reasonable, “what’s in it for me” philosophy, then you might start running for the hills.

Learn to Think PATAB!

You’ve probably never heard of PATAB, and that’s because it’s a term I just created. It means: profits-after-taxes-and-buybacks, as distinguished from ordinary profit-after-taxes.

This graph, using data from Federal Reserve flow of funds account F102, shows the difference between ordinary after-tax accounting profits, and PATAB:

Ordinary after-tax corporate profits, more than tripled between 2002 and Q3 2006, which suggests that everything you’ve read in the Wall Street Journal about this being ‘the best of times’ seems to be true.

However, PATAB earnings failed to recover from the doldrums of the 2000 market crash and show stagnant corporate earnings.

A Look at Price-Earnings Ratios

Another measure of equity value is the price-earnings ratio.

Using Federal Reserve flow of fund data from tables F102 and L202 (total after-tax profits and the market value of non-farm, non-financial corporate business) we see that rising accounting profits caused price-earning ratios to drop from over 40 times earnings (in the post 2000 crash years), leveling off at around fifteen times earnings — ordinarily a sign of a fairly-priced market.

However, the Price-PATAB ratio is something else again, by mid 2006 rising to levels of 50 and 60 times earnings after taxes and buybacks.

If you’re not getting any of this buyback money (you would have to have sold stocks at a handsome profit to qualify) stocks are definitely over-priced for you.

Dividend Yields and PATAB

Finally, we may also examine dividend yields, taking buybacks into consideration. If you believe that buybacks are just another form of dividends, then ‘dividend yields’ on commons stocks over the last few years have been extraordinary — rising to 9% by Q3 2006!

With such handsome yields, and price-earnings ratios hovering around fifteen, and with dramatic growth in corporate earnings — surely stocks must be fairly priced!

But, if you’re not in on the buyback bonanza (i.e., if you’re holding stocks ‘for the long run’), then you’ll want to look at corporate results from a PATAB viewpoint. This shows corporate earnings flat, stocks prices over 50 times PATAB earnings, and meagre cash dividend yields of around 3% — definitely a description of an over-priced market.

Think of Buybacks as a Special Preferred Dividend

If buyback money was being paid to a special kind of preferred shares, rather than being used to repurchase common stock, audited financial statements would routinely show common stock corporate earnings in terms of profits after taxes and payments to preferred stockholders.

However, buybacks fall into a blind space in Generally Accepted Accounting Principles, and are treated neither as an expense, nor as profits paid to another class of shares. The reason for this is that buyback benefits are not a contractual right of a certain class of shareholders, but only a benefice, paid out at the discretion of company directors.

Security analysts who follow the Graham and Dodd philosophy, do not take GAAP profits as the Word from the Almighty, but rather as a starting point for logical adjustments necessary in interpreting investments for particular classes of investors.

Stock buybacks are like a ‘preferred dividend’ to executives who hold stock options at no cost and who give value to their own options by using buybacks to manipulate stock prices upwards, exercising these options, with no risk. The ordinary shareholder, in contrast, can only get some of this buyback money by selling stock that was paid for in hard cash and held at risk.

Generally Accepted Accounting Principles (like most rules) were written in the context of expected corporate behavior — many years ago — but times have changed and what was once considered normal behavior is now no longer the case.

The moment a rule is published, smart people find ways it may be bent to their advantage. In this, they are usually successful, forming coalitions of defenders of rules they believe to be beneficial — usually in ways never intended by the rule makers.

The Great Buyback Loophole

A  problem arises in today’s equity markets because corporate stock buybacks total over one trillion dollars every two years, while the rules that deal with the accounting for stock buybacks date back more than a quarter century, when the practice was of minor importance and relatively rare.

Little serious thought has been given to reexamining methods of accounting for stock repurchases in the light of today’s practices.

Now those who place their hands on Generally Accepted Accounting Principles, as if they were a Holy Book, and swear that the method of accounting for stock buybacks is fair and in the best interest of all shareholders, would seem to be on the side of the angels.

But, as Shakespeare noted, “Even the devil can quote scripture.” To many people, the argument that buybacks are accounted for according to GAAP rules is the end of the matter — a signal to turn off their brains and turn on their TV sets. It’s in the Holy Book of GAAP! Why think about it any more?

And indeed, it is difficult to dismiss the rules and think about what really might be a proper way to account for stock buybacks. It’s much, much easier to dismiss the matter as already settled.

But it would be a worthwhile endeavor, because the Great Buyback Loophole is the rule that governs today’s stock markets.

Profits in the Eye of the Beholder

Reports produced by accountants are supposed to provide useful information to various stakeholders in the enterprise.

For example, a report showing EBITDA is of particular interest to bondholders, seeking to evaluate a company’s capacity to cover interest due on bonds they own.

Today’s accounting reports for corporate stockholders routinely show earnings after taxes, adjusted for payments to preferred shareholders that have a prior claim on earnings.

When Wall Street crows about great corporate earnings, they are usually talking about after-tax earnings available to common stockholders.

It all seems so straightforward — the Word According to GAAP — until we try to deal with massive stock buybacks that dominate the US equity markets today.

The Case of Common A and Common B

You will note that accounting reports generally are bound by the legal rights of various stakeholders in an enterprise — not by customary behavior of directors acting under their discretionary powers.

Corporate director have powers to use corporate assets in ways that often are not in the interests of common shareholders, including their right to determine the remuneration of executives and to approve poorly conceived acquisitions and mergers.

Many decisions of directors have a direct bearing on the amount of profits available to common stockholders, but, according to accounting rules, will not be accurately reflected in reported earnings — a case in point being stock buybacks.

Consider the following situation:

Corporation XYZ has two classes of shares: Common A, that account for 5% of the capital, and Common B, that make up the rest. The by-laws state that dividends paid to Common A and Common B are at the discretion of the directors, and need not be the same.

Now, for over twenty years, Corporation XYZ has paid one thousand dollars per share to Common A shares and one dollar per share to Common B shares. In reporting profits to shareholders, however, the directors show the entire profits as belonging to all common shareholders, before dividends. The habits of the board in distributing these dividends according to the peculiar by-laws of Corporation XYZ are not considered relevant.

The price-earnings ratio for Corporation XYZ is calculated by stockbrokers and the financial press (who are friendly with the directors), are on the basis of earnings before dividends, as is customary. When these earnings increase, stock prices rise in line with the price-earnings ratio.

Is this correct and proper?

The directors of Corporation XYZ argue that dividends paid to Common A shares should not be deducted from reported earnings because:

1. Common A has no legal right to any differential dividends from Common B;
2. Dividends paid to Common A have exactly the same accounting treatment as dividends paid to Common B, and both are in accordance with GAAP;
3. Maybe next year, the directors might decide to pay $100 per share to Common B and no dividends to Common A, in which case, to try to report profits “available to Common B” would be shown to make no sense.

Now maybe you have an easy answer for this case, because there are two classes of common shares. Or you may think that no stock exchange would list a company with such strange rules. However, the point being made is that accounting standards do not necessarily present information fairly to all shareholders.

Now, lets advance to a case with only one class of common shares.

The Case of the Foreign Investors

Country ABC has a law that requires foreign investors to get government approval before selling common shares of domestic corporations. This approval takes many months and usually is conditioned on paying a high excise tax and repatriating the proceeds of the sale. Consequently, foreign investors in Country ABC are generally long-term investors, looking mainly to dividends as a return on their investment.

Company XYZ in Country ABC is held one-third by domestic investors and two-thirds by foreign investors, with directors chosen by domestic investors. The directors, inspired by the behavior of directors in the US market, decide each year to declare large stock buybacks and, at the same time, offer all domestic shareholders options to buy an equivalent amount of stock as the amount repurchased at one-half the buyback price.

As a result of this policy, almost the entire profits of the company are used each year for stock buybacks. Domestic shareholders use options to acquire shares to sell into these buybacks, but foreign shareholders, because of government restrictions, can not take advantage of the buyback program.

Foreign shareholders in Company XYZ are required to declare earnings in foreign holdings, even undistributed, with certain tax consequences. The foreign shareholders in Company XYZ complain to their government that this is not fair, because these so-called “profits” are, in fact, used to pay for buybacks. Their government, however, is unsympathetic because, according the GAAP rules, funds used for buybacks are not an expense and should be included in profits.

So here we have a case in which GAAP rules are clearly misrepresenting the earnings of Company XYZ from the point of view of the foreign shareholders.

Most US Common Stock Investors Buy ‘em and Hold ‘em!

There are several things to note about the buyback movement and the behavior of US stockholders:

• Most US investors buy and hold common stocks for long periods, selling only when they retire decades later. Stocks are often held in tax-deferred plans that impose penalties for cashing out too soon. A large portion of investor money is held in equity funds, which means, in essence, that investors are permanently in the stock market.

• A minority of US investors have a stake in corporations, achieved not by holding common stock for which they paid in full, but rather as options, issued without cost, in virtue of their position. This class of common stock investors, in essence, holds shares at no-risk and receives ‘dividends’ of stock buybacks by exercising options for a assured profit.

Most US investor get investment advice from Wall Street brokers and fund management companies that have an interest in portraying common stocks in the best light. Generally Accepted Accounting Principles, by not requiring any special treatment of buybacks, allows Wall Street marketing people to mislead investors, with no fear of criticism from the SEC.

So, now you know. If you benefit from corporate profits as reflected in GAAP (that is, if you are a stockbroker, fund manager, or anyone whose remuneration to tied to accounting profits) then these are indeed the best of times.

However, if you are a modest, long-term investor, trusting implicitly in representations of Wall Street marketing men and women, and if you hold much of your retirement money in common stocks, then you have reason to be alarmed.

How To Create a Bonanza of Real Value for US Common Stockholders

You may have noticed from the above graphs that if Wall Street were to reform, demanding that the money now spent as buybacks be distributed, instead, as ordinary dividends, fairly and equitably to all shareholders, most investors would suddenly be justified in holding common stocks:

• Cash dividend yields would be over 9%, a premium over bond yields comparable to pre-1960 long-term averages.
• Price-earnings ratios would be about fifteen, in line with long-term consensus for a fairly-priced market.
• Corporate earnings would be increasing in line with inflation.
• Total cash return to long-term investors would be consistent with common expectations used in planning for retirement goals.

The chances of this happening are not great.

Common stock investors just don’t know what is going on and Wall Street is not about to tell them. So, in the meantime, unless you are lucky enough to be a beneficiary of the corporate handout, you might consider viewing claims of extraordinary good corporate results with a dose of skepticism.