Federal Reserve flow of funds accounts for Q1 2006 show the degree to which equity investments have fallen out of favor with individual investors.

Flow table F100 (Households) reports annual rates of net direct sales of equities by individuals of $866.5 billion, an all-time high.

This selling is interpreted as reflecting executives exercising stock options in a massive transfer of corporate wealth to favored insiders through buybacks.

On the other hand, net purchases of equities by individuals via mutual funds — for many years a pillar of the stock market — was only $205.1 billion in Q1 2006 (annual rate).

This means that net disinvestment in equities by individuals was $670.9 billion (annual rate) in Q1 2006 — a record!

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The Efficient Market Hypothesis continues to impede understanding of how capital markets work.

The front-page article in the WSJ of June 12, 2020, announcing record levels of stock buybacks, continued to promote a common misperception that stock repurchases enhance equity prices by the following mechanism:

1. By reducing the number of shares outstanding through buybacks, earnings per share increase;

2. Investors, noting this increase in earnings per share, are willing to pay higher prices;

3. Therefore, buybacks. by increasing earnings per share, cause prices to rise.

This, of course, is in line with the Efficient Market Hypothesis, and depends upon the assumption that increasing earnings per share improves intrinsic value and that a crowd of rational, competing, profit-maximizers will therefore force prices upwards.

Ignoring the Evidence

The popular line of reasoning of the WSJ ignored Federal Reserve flow of funds accounts that showed that something far removed from the Efficient Market Hypothesis was driving the market in Q1 2006:

1. Corporations were spending vast sums (more than $146.7 billion) to take stocks off the market with the intent of directly manipulating prices upwards;
2. Individual, sophisticated investors, dealing in specific stocks, were not bidding up prices because of enhanced earnings-per-share, but rather were selling out on a grand scale ($216.6 billion) — cashing in their stock options;
3. Unsophisticated investors (according to surveys by the Investment Company Institute) were naively buying ’stocks for the long run’ through automatic payroll deductions channeled to tax-deferred mutual funds, with no perception, whatsoever, of changes in earnings-per-share of individual securities.

The WSJ interpretation of the record level of buybacks, supported by the Efficient Market Hypothesis, puts a spin on events that is far kinder to corporate executives, stock brokers, and option exercisers, than the unvarnished truth that prices were supported not by improved earnings per share and crowds of rational investors seeking ‘intrinsic value’, but rather by the brute force of $146.7 billion in corporate cash being applied to take stocks off the market from option holders, many of whom were the same executives ordering the buybacks.

Furthermore, what was going on in Q1 2006 was not some random event — mere noise in the market — but rather the continuation of a long-standing pattern of behavior involving corporations, option-holders, and mutual fund investors that has been going on for many, many years.

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On April 26, 2020 at the Milken Institute in Los Angeles, California, at the Milken Institute Global Conference for 2006, the topic “Baby Boom — Baby Bomb?” was debated by Michael Milken, Chairman of the Institute, and Professor Jeremy Siegel, of the Wharton School, University of Pennsylvania. The debate was moderated by Paul Gigot of the Wall Street Journal.

This debate was of such significance as to be featured in BusinessWeek on June 5, 2020, in the article, “When Boomers Cash Out: A buy-and-hold legend sees tough times ahead.”

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