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!

The Harvard Business Review of February 2007, featured its list of “Breakthough Ideas for 2007″ which sheds light on the regard that US business executives and their mentors now have for ordinary stockholders.

Now, I wouldn’t ordinarily give much attention to an HBR article, but this featured piece claimed to be a “List of Breakthrough Ideas for 2007!” — deemed “provocative and important” by HBR editors — the result of ‘brainstorming’ seminars at the World Economic Forum and discussions among the high and mighty in Davos, Switzerland.

Eureka!

There is nothing like a proclaimed “breakthough idea” to provide us with insights into the minds of those who run the world.

What a Dilemma: Lots of Cash and No Brains!

Breakthrough Idea No. 8 (of the HBR list of 20) was entitled “Borrowing from the PE Playbook” and presented a solution for executives that, as a result of cost cutting and improved productivity, now had an embarrassing “mountain of cash”.

Here is how the case was framed:

“A cash mountain used to be considered a good thing — savings for a rainy day or a war chest for future acquistions. Today, it’s a mixed blessing, and the possibilities for spending the cash wisely are much reduced. For one thing, profitably emptying a war chest isn’t as easy as it once was. Private equity firms are hunting for big corporate deals and using their financial leverage to bid up the prices of acquisition targets — effectively pricing ’strategic buyers’ out of the market.”

“But keeping the cash in the bank isn’t an option. Not only does it generate embarrassingly low returns for investors, but it can make a company more attractive to PE firms. … “

“Some companies resort to share repurchases, but these create value only if the company is undervalued by investors — which is the exception, not the rule.”

“Giving the cash back to shareholders in the form of dividends isn’t a very attractive alternative: It effectively signals that management has run out of promising new growth ideas, which will inevitably effect the share price.“

Huh? Hold it, right there!

Lets get this straight:

• A company is sitting on a “mountain of cash” and doesn’t know what to do with it.
• Stock prices are so high that buying other companies is not easy and equity repurchases are not justified.
• Management doesn’t have any idea what to do with the money, but doesn’t want shareholders to know.

Do Investors Really Despise Dividends?

It used to be — in olden times when common stocks were newly invented — that the whole purpose of buying stocks was to receive dividends when a company was profitable.

It would seem to me, as a humble investor, that a handsome dividend paid as the result of cost savings and productivity gains, should make management look good — at least to my eyes.

After all, dividends are the highest form of “return on investment” — the be-all-and-end-all of John Burr Williams’ formula for valuing equities.

But the Harvard Business Review says that dividends are not only not “attractive”, but furthermore, according to the murky ethics of the Harvard Business School, executives should conceal from shareholders the fact that they’ve run out of ideas of what to do with shareholders’ money, and ought to hold onto to it anyway.

Keep Shareholders’ Cash and Don’t Let Them See You Sweat!

The author of Breakthrough Idea No. 8 goes on to advocate that, rather than pay dividends to stockholders, the wise executive should gamble with the shareholder’s money, trying to buy other firms in an admittedly over-priced, highly competitive market in which management is said to have little experience!

The HBR article claims:

“Like it or not, acquisition really is the only option.”

Really? The only option? How about dividends that were so disparagingly dismissed?

I’m sure shareholders would prefer to receive their money than to have executives piss it away, trying to compete in an overheated acquisition market, about which they know little.

And how about ethics and morals?

Is it right to keep shareholders’ money so they won’t guess that you don’t wake up each morning with a bright new idea of how to make a gazzillion dollars!

Yes, boys and girls, save your money and when you grow up, you too, like Jeff Skilling, can go to Harvard Business School and get your own shiny new “Breakthough Idea”.

Politics in America has been transformed from being merely crass and corrupt into being overtly suicidal and wildly insane. Believe it or not: the future of the Democratic Party now depends upon the United States losing the War in Iraq.

Anything less than bitter defeat for US troops and outright triumph for Muslim extremists may lead to a Republican victory in the 2008 elections.

For Democrats, Victory in Iraq would be intolerable; their defeatism would have been proven wrong. They would be exposed as unpatriotic fools and cowards. For them, a win in Iraq is simply not an option.

This might not mean much, except that the Democratic Party now controls Congress and is supported by the vast persuasive power of the liberal media, the entertainment elites, and the universities.

Betting on US victory in Iraq is no longer a safe wager. So its time to adjust one’s investment strategy in expectation of a US defeat in Iraq and a consequent nuclear attack on a major city, probably New York.

Bearing Any Burden or Hardship — To Ensure Defeat

I  am struck by the lone, pathetic figure of Senator Joe Lieberman, now an outcast from his party, wistfully longing for the days of Franklin Roosevelt, Scoop Jackson, and John Kennedy, when a Democratic politician actually declared:

“Let every nation know, whether it wishes us well or ill, that we shall pay any price, bear any burden, meet any hardship, support any friend, oppose any foe, in order to assure the survival and the success of liberty.”

Those days are gone forever.

Although Democratic politicians still give sniveling lip service to “supporting the troops”, they are loathe to go so far as to support the commander of the troops, or any tactics or strategy that might lead to victory, or to endorse the purpose of the war (which might imply that soldiers had not died in vain), or even to assure fighting men and women that they won’t be cut off without funds, left in harms way, scrambling to escape, as Democrats did to troops in Vietnam.

Nor will Democratic politicians shrink from giving aid and comfort to the enemy by telling them their intention of stopping military funding, or to call for a vote of no-confidence on the purpose of the war or any policies that might lead to victory, or from cheering when the New York Times reveals state secrets to Al Queda, or from promising to impeach the Commander in Chief, presumably for the “high crime and misdemeanor” of attempting to protect the American people from a vicious enemy, or from blaming the war entirely on George Bush being “stubborn and arrogant” and misusing power, as Hillary Clinton did recently in an Arab newspaper.

Over the next two years, hundreds of millions of dollars will be spent on anti-American propaganda, not by Al Queda, but by the Democratic Party, intent on undermining the US Commander in Chief in time of war, drumming up support for impeachment and immediate withdrawal at all costs.

These millions in defeatist advertising will be multiplied many times over by “free propaganda” from American media barons who are absolutely determined that Republicans must not win in 2008, no matter what the cost to the nation.

As the Democratic front-runner, Hillary Clinton, revealingly proclaimed, “The president has said that this [war against Al Qaeda] is going to be left to his successor. I think it’s the height of irresponsibility and I resent it.”

Of course, she resents it! The very idea that she might become president and assume the role of Commander in Chief with an actual war to fight is repugnant, not only to her, but to any rational person who understands that she is simply not up to the task.

She longs for the ‘piping times of peace’ when she can wile away long summer afternoons in the White House, dreaming up health care schemes and ways to tax the middle class.

A Sign of the Times: Jane Fonda is Back!

The stench of defeat in Vietnam whiffs through the halls of Congress.

Jane Fonda, notorious for giving aid and comfort to the enemy in Hanoi two generations earlier, is back, again urging defeat and surrender.

As is John Kerry, the ‘Winter Soldier’ and one-time presidential contender, calling for retreat from a safe spot on the Senate floor.

Now the one thing that still gets in the way of quick and sure defeat is this annoying crap about “supporting the troops”. The Democrats just hate it, but they still have to say, “I support the troops”, no matter how patently false that sounds.

But wait, if Hanoi Jane is back, why not dig up something like the massacre of My Lai? That shouldn’t be too hard for the enterprising boys and girls in the US press. Surely, some gory pictures of dead Iraqi women and children can be found to blame on US troops, and with the media in full bay, calling for an “investigation”, it shouldn’t be too hard to turn American soldiers into villains, unworthy to defend the country.

It doesn’t need to be true: it’s the thought that counts.

With this, our ‘leaders’ in Hollywood and Harvard can practice hawking up phlegm in their throats, getting primed to spit on returning troops. That should put the crowning touch to defeat.

Ridiculous? Don’t bet on it. The Democrats have to win at all costs, and, as the saying goes, politics ain’t bean bag.

Sell Manhattan Real Estate — While There’s Still Time

In 2002, a famous Democrat, Warren Buffett, said he thought that a nuclear attack on American soil was “a virtual certainty” and that mankind was hurtling “toward something equivalent to extinction”.

Another famous Democrat, former Senator Sam Nunn, Co-Chairman, Nuclear Threat Initiative of the Carnegie Endowment for International Peace, said in 2002 that “the gravest danger in the world today is the threat from nuclear, biological, and chemical weapons”, and that “the likeliest use of these weapons is in terrorist hands.”

In 2003, Jessica Stern, lecturer in public policy at Harvard’s John F. Kennedy School of Government, said: “the prospect for terrorist groups to get access to nuclear and biological weapons is a very, very grave threat.”

In 2004, Graham Allison, director of the Belfer Center for Science and International Affairs at Harvard University’s Kennedy School of Government (definitely not a conservative think tank), lamented:

The holes in our borders — from the thousands of cargo containers arriving in the port of Boston unopened, to the sailboats arriving on the Massachusetts coast from Canada without going through any customs procedures, to the automobiles, trucks and backpackers crossing the border from Canada to Maine or Vermont — allow 300 tons of cocaine to be smuggled into the United States each year. Because the radioactive core of a nuclear bomb easily could be shielded from radiation detectors and would fit in a container the size of a six-pack of beer, the chances of intercepting it en route are not good.

So it is not that the Democrats are unaware of the nuclear threat to the United States or that the primary danger comes from Muslim terrorists, nor that defeat in Iraq would embolden sworn enemies of the American people.

The fact is that Democrats would rather run the risk of losing New York City in an atomic blast than losing the 2008 election to the Republicans. Maybe not all Democrats, but enough to lose the war.

I guess that, like the cynical attitude of Muslim terrorists about blowing up their own people (“Allah will know his own”), Democrats may figure that fellow Democrats that turn into radioactive dust in a New York holocaust will have died in a good cause.

Now, with estimates of the probability of a nuclear attack on the US ranging from an optimistic 29% to Warren Buffett’s 100%, I’d settle for 50% as a reasonable guess of the likelihood of full scale atomic attack on New York City (the prime and most obvious terrorist target.)

So, in view of the goals of the Democratic Party that now controls Congress, the press, and the universities, here are some thoughts for careful investors:

• Get out of NYC real estate, while there’s still time;
• Switch financial assets to companies headquartered outside of Manhattan;
• Review the chances of the investment survival of your portfolio, in the event of a nuclear attack on the US.

PS: Don’t count on it being just a dirty bomb.