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!

A  self-proclaimed ‘independent, non-partisan’ group of investment bankers, hedge fund operators, leveraged buyout experts, venture capitalists, fund managers, lawyers, accountants, and closely associated academics formed a “Committee on Capital Market Regulation“ that issued a report on US equity markets on November 30, 2020, after less than two months of deliberation.

The announced purpose of this Committee is to ‘recommend policy changes that should be made, or areas of research that should be pursued, to preserve and enhance the balance between efficient and competitive capital markets and shareholder protection.’

Because this group is extremely well-financed and well-connected, with the ear of the US Securities and Exchange Commission and the Democratic-controlled Congress (through the Brookings Institution, a Committee member, and through Wall Street financial contributions to Representative Barney Frank), its recommendations may effect the future of US capital market regulation for years to come.

There are no representatives of small shareholders on this Committee, and in this regards, the Committee is truly independent from inconvenient opinions of common investors, who blindly trust in Wall Street and the Common Stock Legend, channeling their life savings through retirement funds into equities and 401(k) and IRA plans.

Why Is Sarbanes-Oxley So Hated By Wall Street?

The main recommendation in the first report of the “Committee on Capital Market Regulation” is to weaken provisions of Section 404 of the Sarbanes-Oxley Act of 2002 that call for effective internal controls over accounting practices of public companies.

The Committee reported (in mock horror) that the incremental annual auditing cost incurred under Section 404 for public companies, averages about $4.3 million.

Although this cost is only about 30% of the annual pay of the average CEO of a Fortune 500 company and is falling rapidly as companies establish essential systems of internal controls, the Committee claims this burden to be intolerable, leading to a loss of competitive advantage of Wall Street bankers when soliciting the underwriting of foreign issues into the US market.

However, the Federal Reserve flow of funds accounts show that claims of declining new offerings by foreign issuers in the US market are simply untrue. (See: “Foreign Stock Issues Continue Despite Sarbanes-Oxley“)

Furthermore, sound internal controls are merely a cost of good management and a lack of controls can have disastrous consequences for shareholders, as has been seen with Barings Bank and Enron.

An understanding of the principles of internal controls is not a required discipline to be mastered by graduates of the Harvard Business School. Skills in the more exciting field of “creative finance” are considered more relevant than the dull task of assuring that financial reports are correct or that someone is not stealing a company from under one’s nose.

However, it seems likely that Section 404 is merely a straw man for the real, unspoken objection that Wall Street has to other sections of Sarbanes-Oxley:

Section 401(j) requires that executives certify financial reports as true, and Section 906 provides fines of up to $5 million and up to 20 years in prison for “failure to certify”. (See: “Sarbanes-Oxley and the Shortage of Equities“)

It is much more seemly for executives to righteously point to “excessive costs” and “loss of competitive advantage” supposedly due to Section 404 and “over-regulation” than to admit that they fear stiff penalties for sloppy financial control of public companies imposed by Sarbanes-Oxley.

It is likely that while headlines focus on “reforms” of Section 404 and “improved competitiveness” , the more objectionable aspects of Section 401(j) and Section 906 will be quietly killed in the dead of night by staffers on Barney Frank’s House Financial Services Committee.

Why Barney Frank Will Weaken Sarbanes-Oxley

The new Democratic-controlled Congress will have Barney Frank, the representative of the 4th District of Massachusetts, as Chairman of the House Financial Services Committee.

Representative Frank has already announced before the Greater Boston Chamber of Commerce his intention to weaken Section 404 of the Sarbannes-Oxley Act, citing as justification many of the same reasons (with the same wording and phrases) as in the report of The Committee on Capital Market Regulation.

This is not surprising. The largest contributions, by far, to Barney Frank’s election campaign of 2006 came from Wall Street, led by JP Morgan Chase.

Now, there never was the slightest doubt that Barney Frank would win the 2006 election in the 4th Congressional District of Massachusetts, as he had in every election for over a generation.

• First: The 4th Congressional District is Barney Frank’s own personal pet Gerrymander — a true marvel of American Democracy that assures his reelection year after year.

• Second: In some years, Barney Frank even runs unopposed. In 2006, there was no Republican candidate and only a weak Independent with no chance of winning.

Therefore, the only reason for Wall Street’s massive campaign contributions to Representative Frank would have been to buy access and a sympathetic hearing for their views, especially with regards to Sarbanes-Oxley and SEC regulation.

The timing of the formation of the Committee on Capital Market Regulation, the ties of its members to Barney Frank, and Representative Frank’s quick parroting of the Committee’s views before the Greater Boston Chamber of Commerce, all lead me to believe that the House Financial Services Committee over the next two years will seek to weaken, rather than strengthen protection for American small investors. (See: “Is the SEC Obsolete: Problems with Non-Merit Regulation“)

Wall Street Will Continue To Lose Competitive Advantage

Of course, with or without Sarbanes-Oxley, Wall Street will continue to lose competitive advantage to foreign capital markets, as has occurred over the last fifty years.

In 1956, when I first went to work on Wall Street, New York City was the undisputed financial center of the world. Europe and Japan were still digging out from the rubble of World War II, London was laboring under socialist government, and the emerging markets of Latin America and Asia were not even imagined by the wildest visionaries.

For the rest of the century, the United States, with Wall Street playing a leading role, worked to fortify the economies of the rest of the world. US investment poured into multi-national corporations that went to build economies, not only in Europe and Japan, but throughout the third world.

US bankers, along with dollar financing, brought techniques of Wall Street to every non-communist country — and after the fall of the Soviet Union, even to the communist world.

From the 1970s onwards, the World Bank, USAID, and the Asian Development Bank, spent hundreds of millions building capital markets in virtually every nation on earth, sending consultants, experts, and advisers from the United States.

Citibank, with the Group of Thirty, led the effort to improve clearings and settlement worldwide.

The SEC, through IOSCO, championed orderly market development along the US model, in hundreds of countries.

See: Globalization and Capital Flows

By the 1990s, with the fall of the Soviet Union, new stock exchanges came into being in every corner of the globe, from Albania to Zimbabwe, and from Angola to Uzbekistan.

Furthermore, Wall Street firms set up offices in developing markets overseas and vigorously competed for underwritings and the business of local issuers and investors, trading on local stock exchanges, and adopting business plans calling for development of foreign markets, rather than the channeling of business to the United States.

So the lamented loss of “competitive advantage” by Wall Street is pure hooey — a weak excuse by ethically challenged corporate executives to avoid accountability to shareholders.

It has nothing at all to do with Sarbanes-Oxley or over-regulation, but is instead the inevitable consequence of globalization — a large part due to the efforts of Wall Street itself — and the relatively fast growth of the rest of the world, compared to the United States.

A Committee on Capital Market Regulations Could Be Useful If …

Now, there is no doubt that a Committee on Capital Market Regulation that would do all the things this Committee proposes is sorely needed and could be most useful if set up to seek ways to better protect investors and correct distortions in the US capital market. For example, something should be done about the great stock buyback scam, the overpaid corporate executives, and the demise of dividend yields.

But, I’m afraid, judging from this first report, this Committee is likely to champion the status quo and serve interests of its members, rather than suggest reforms that might benefit the great mass of investors or that would ensure a healthy US capital market.

The correct answer to this question is, “Of course, the U.S. trade deficit is not sustainable.”

But then, what is? Neither the Roman nor the British Empire endured. Economic and political phenomenon eventually fade and die. Indeed, the U.S. trade deficit, one day, like everything else will be a thing of the past.

A more practical question would be, “How much longer might the U.S. trade deficit last? One year? Ten years? Thirty years?”

Some observers may presume that the demise of the trade deficit is imminent, perhaps by the end of 2006; but, it this reasonable?

The trade deficit has been growing for thirty years — which almost qualifies as a Keynesian ‘long-run’ . Since no clear mechanism exists whereby the trade deficit must end in, say, six months or a year, it could be that in thirty years our children will still fret about a trade deficit that has grown even larger.

The longevity of the U.S. trade deficit is quite germane to Capital Flow Analysis, since it is the dollars earned by foreign exporters that support the price of American bonds.

(See: “Trade Deficits Have Depressed Bond Yields for Twenty Years.”)

It is worthwhile to speculate about the sustainability of the trade deficit.

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