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):

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:

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.

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!

	US Dollar Devalued Against Brazilian Real

The reason for the strong real is the excess of Brazilian exports over imports, the result of government policy encouraging exports and discouraging imports. This has led to ever-larger dollar reserves.

Government policy resulting in extremely high internal interest rates attracts holder of these dollar reserves to invest in short-term Brazilian debt.

This is possible because of a convertible currency and dollar-real derivative products that allow foreign investors to take advantage of these high rates, while hedging against a possible decline in the value of the Brazilian real against the dollar.

Brazil has a cornucopia of valuable commodities to sell into world markets: iron ore, manganese, soybeans, coffee, cotton, castor seed, tin, rice, cashew, aluminium, black pepper, corn, and many other things.

In addition, Brazil has a powerful industrial base with low labor costs, producing everything from jet planes to automobiles to machine tools.

Brazilian exporters have a neo-mercantilist mentality, which means that they want to sell goods and commodities to receive hard currencies, primarily dollars. Brazilian economists and central bankers regard a surplus of dollar reserves as a good thing.

Heavy Tariffs Restrict Imports

The Brazilian authorities keep a large portion of export dollars by maintaining high tariffs and setting tough bureaucratic restrictions that discourage imports.

When all tariffs, imposts, and taxes are summed, the cost of imports landed in Brazil often exceeds 100% of the price received by the foreign exporter. These high costs protect local industry and keep imports lower than exports.

In 2006, Brazilian imports were 66% of exports. In Q1 2007, imports rose to 74.3% of exports. The resulting trade surplus exceeded Brazilian foreign debts.

High Taxes and Low Inflation

In recent years, Brazil has been able to overcome endemic inflation that has been the pattern for the last 400 years.

The key to this has been the imposition of taxes at a level that covers heavy government spending, soaking both the rich and the poor with value added, sales, and income taxes that eat up a large portion of the cost goods bought and sold.

Not only are taxes high, collection methods are intrusive. Residents of Brazil must have a tax number (CPF) that appears on checks, contracts, and bills of sale.

This makes it possible for the government to track individual spending habits and spot those with expenditures that seem to exceed reported income.

Big Brother is alive and well in Brazil.

High Interest Rates, Low Inflation, and Convertible Currency

Interest rates in Brazil, adjusted for inflation, are among the highest in the world.

This fact, together with a currency strengthening against the dollar, easily convertible, with availability of derivatives to hedge against currency risk, attracts foreign short term investment that further drives down the dollar against the Brazilian real.

The relationship between a trade surplus and interest rates that attract short-term investment, does not signal long-term weakness in the dollar, but rather a a temporary, short-term aberration brought about by Brazilian policies that are probably not sustainable in the long run.

The strong real against the dollar is already causing complaints from Brazilian manufacturers that are being priced out of world markets. Under employment and unemployment are high.

If current high-interest, high-tax, and hard currency accumulation policies continue, slow growth is inevitable and the poor in this lower middle income economy must accept living in poverty for the foreseeable future.

Why Things Are Not So Rosy

Despite the recent positive performance of the Brazilian real versus the US dollar, it would be a mistake to regard this either as a permanent trend or a sign that Brazil is now in the same category as successful economies like Singapore, Hong Kong, or Japan.

Although the rating services have upgraded Brazilian foreign debt, this paper is still one or two notches below investment grade. The GDP growth rate is now only 4.3%, far below the levels of the years of the Brazilian Miracle and insufficient to raise the standard of living of most Brazilians who are dreadfully poor.

Brazil is still classified by the World Bank as a Lower Middle Income Economy.

Although the left-wind government of President Lula has managed to stay in power by reducing inflation and by demagogic appeals to the masses, the price of rigorous inflation control is high taxes and high interest rates that repress economic growth.

Furthermore, the Brazil has an Economic Freedom Rating of only ‘moderately free’ and a Corruption Perception Index of 3.7 (out of 10).

Failure of Government’s Prime Responsibility

The Lula government has failed to maintain social order in major cities where drug lords and street gangs kill innocent citizens at will, daily.

No one knows for sure the death toll from crime in Brazil. One newspaper puts the annual homicide rate at 50,000 — a full scale war on a par with Iraq — while left-wing supporters of the government characterize the problem as “no worse than the United States” and “grossly exaggerated”.

However, the newspapers, which are still free, continue to herald the latest battle in a losing war against street crime, with news of daily shoot-outs between police and criminals, with lists of innocent civilians caught in the cross-fire.

The Girl from Ipanema now lies dead on the sidewalk, a victim of a stray bullet, as the posh bairro of Ipanema becomes what is described by O Globo as a war zone.

Residents fear to go into the streets of the major cities, even in broad daylight.

The dominance of criminal elements in society has grown steadily since leftist governments took over from the military in the early 1980s, and, with the end of the years of the ‘Brazilian Miracle’, crime should now be a major consideration in any economic evaluation of Brazil.

Dissatisfaction with the Lula government, which is generally characterized as corrupt, soft on crime, and and given to leftist folly, is evident from Brazilian newspapers or by talking with cab drivers in the large cities or people on the street. Something will give, sooner or later, and any significant political shift can cause the derivatives that now support the real-dollar rate to unwind.

How A Weak Dollar Signals Strength

If the dollar was not popular with Brazilian exporters and if the Brazilian government did not seek to build dollar reserves, there would be no excess dollars in Brazilian foreign accounts to swap into short-term Brazilian debt to take advantage of the high interest rates that restrain growth and inflation.

High real interest rates and taxes depress the rate of expansion of per capita GDP, which, in a country with an ever-widening gap between rich and poor increases political instability. The strong real against the dollar, reduces employment in the industrial sector, while easing up on import restrictions would damage domestic industry even more. With already high rates of unemployment, a strong real is not good news for the Brazilian economy.

Meanwhile, the rest of the world continues to build dollar reserves, as evidenced by the expanding US trade deficit.

I wonder who now has taken his place, at the height of the Great Buyback Bubble and whether they will suffer the same fate as Mr. Skilling, when the market comes tumbling down?

Corporate executives have thrown caution to the wind, touting buybacks as ‘good for investors’ without regard for the truth or laws against securities fraud. Even when borrowing heavily to finance buybacks, lowering credit ratings of company bonds, mortgaging the future of companies at ever higher cost, these executives don’t seem to care.

However, reckless arguments supporting today’s buybacks will carry little weight in the vindictive climate of a post bubble bust.

Perhaps, in the back offices of law offices specializing in class action torts, modern Madame DeFarges are quietly knitting the names of the buyback artists … preparing for the day, after the crash, when the tumbrils will again roll through Wall Street, carrying today’s wrong doers to the justice of the mob.

	Is There a Madame DeFarge Knitting the Names of Culprits?

Supreme Folly: Borrowing to Finance Buybacks

According to Federal Reserve flow of funds accounts, a large portion of today’s stock buybacks are financed by borrowing heavily and dipping into depreciation reserves. Nevertheless, corporate executives continue to justify buybacks as “just another form of dividends”, bringing the supposed benefit of “increased earnings per share”.

Even the slowest of minds should be able to grasp the fact that borrowing to finance buybacks results in interest costs that will reduce, not improve future profits. Furthermore, when the rating agencies view the practice negatively, the cost of all borrowing by the company goes up, not only the cost of loans taken to finance buybacks.

But, as is the rule in Great Bubbles, not only the slowest thinkers, but even the best and the brightest, don’t seem to get it.

It will taken a drastic reduction in book wealth for the truth to sink in. And then, perhaps, Madame DeFarge will be ready, with her knitted list of wrong doers, ready to feed the inevitable thirst for mob vengeance.

Stay tuned …

Most investors will pass through these days of madness, hardly appreciating the spectacle that surrounds them.

However, I will step into the breach and make an unsolicited public service announcement:

The Great Buyback Bubble is now official! Look around you and behold!

The Federal Reserve flow of funds accounts have signaled that there is a massive disequilibrium in the US equity market for over a year, and my ‘Googlemeter‘ brings daily emails documenting increasing symptoms of irrationality in the feverish buyback market.

Major companies now borrow heavily to transfer corporate cash to speculators and to their own executives through the magic of ‘buybacks’. Rating agencies are downgrading credit scores of major companies that prefer to squander shareholders’ funds in pursuit of a transitory up-blip in equity prices, at the expensive of the well-being of not only their permanent shareholders, but of the economy and the nation as well.

And the amounts involved in buybacks are truly impressive, now exceeding one trillion dollars in less than two years.

The Federal Reserve, the Securities and Exchange Commission, and Congress are confused and unsure of what it all means.

Except that one thing is certain: when the buybacks stop, the market will crash. Buybacks are the only thing keeping stock prices up.

Signs of the times

Two items that came in recently really rang a bell, indicating that we are indeed living through perilous years of speculative froth:

• Paul Krugman, a world famous Princeton economist writing for the New York Times, published an article about, “The Disconnect Between Profits and Investment” on April 30, 2007;

• Paul Hickey and Justin Walters of Bespoke Investment Group published an item in Seeking Alpha, entitled, “Amazon’s Most Profitable Business: Buying Back Its Own Shares” on May 1, 2007.

What is so interesting about these articles? Why do they confirm that the Buyback Bubble should now be considered official?

Paul Krugman Blames Buybacks on Bush

Professor Krugman, like many others, has noticed the buyback boom, but, his article suggests that he thinks that this behavior is somehow new — undoubtedly the product of the misguided Bush administration.

He writes:

In “the Bush years high profits haven’t led to high investment, and rising productivity hasn’t led to rising wages. … Why aren’t corporations investing, and what does the lack of business investment mean for the economy? … many companies are using profits to buy back their own stock. And cynics suggest that the purpose of these buybacks is to produce a temporary rise in stock prices that increases the value of executives’ stock options, even if it’s against the long-term interests of investors… Researchers at the Federal Reserve have found evidence that company decisions about stock buybacks are strongly influenced by “agency conflicts,” a genteel term for self-dealing by corporate insiders…. we now have an economy with incredibly high profits and surprisingly low investment. This raises some immediate, short-run concerns… optimistic projections for the economy depend on vigorous growth in business investment. And that doesn’t seem to be happening. … High investment in equipment and software was one major reason for the productivity takeoff that began in the Clinton era, and continued in the early years of this decade. And low investment may be one reason productivity growth has slowed….”

An economist who believes in the “Rational Man” might see a “disconnect” between how corporate managers behave and how they are presumed to behave, but this is merely an indication of the Irrationality Axiom used in capital flow analysis — in fact, a disconnect between the persistent fantasies of theoretical economists and the real world.

Professor Krugman is correct in suggesting that stock buybacks on the current scale are not proper and are detrimental to the economic future of the country.

However, the professor goes astray by suggesting that this behavior is somehow new — a result of President Bush’s wrong-headed policies and a detour from the wise economic path followed in the Clinton years.

The fact is that corporate executives have been playing the buyback game now for over fifteen years! Buybacks were the major factor in the so-called Dot.com Bubble of the 1990s, the Clinton years, which ended with the Crash of 2000, wiping out more investor value than any time since the Great Depression.

Emulating Rosy O’Donnell

But what is really exciting about Professor Krugman’s article is how he emulates Rosy O’Donnell, misinterpreting the facts and politicizing a long-term behavioral pattern that, in fact, has been bipartisan.

The tricky thing about economic bubbles is knowing how to deflate them without decimating the savings of a major segment of the population. However, the Democratic Party is entirely dependent upon losing the War in Iraq in order to put Hillary Clinton in the White House, and a stock market crash just before the election that could be blamed on Bush would be a nice extra bonus — a cherry on the cake, so to speak.

Now, no one knows when the Great Buyback Bubble will implode, but the Democratic Party would be far better off if this happens while George Bush is still in office, rather than during the first term of President Hillary.

So, when I read an article by a left-wing economist, a perennial Bush-basher, with the bully pulpit of the New York Times, attacking buybacks with political motives, I would say its time to be out of equities.

Remember, Barney Frank now oversees securities markets in the US House of Representatives.

	Getting out before all birds start pointing south ...

Crashing the Market for Political Gain

Here’s how easy it would be to crash the market:

• Pass a law removing double taxation on dividends (President Bush would certainly sign that!);

• Pass another law increasing the capital gains tax on executive stock options, in proportion to the percentage of profits paid out in buybacks, up to 90% (An appeal to populist sentiment against greedy corporate executives).

The SEC has been asleep as regards the perils of buybacks and a small poke in the ribs from Congress (now controlled by the Democrats) could produce a rule that would stop buybacks in a heartbeat, which in combination with skewing tax incentives would crash the market.

And since the great masses don’t know what is going on anyway, the ensuing economic disaster, like Hurricane Katrina and Global Warming, could be blamed on George Bush.

If the Democratic Party is willing to lose a War to gain a presidency and a few seats in the Senate, why not take away the savings of long-term investors while you’re at it — after all, most long-term investors are probably Republicans — and big Democratic speculators, like Soros, will be able to profit by selling short.

Securities Analysts Gone Wild!

The second sociological artifact of the Buyback Bubble is an article by Paul Hickey and Justin Walters in Seeking Alpha, that may have started Ben Graham spinning in his grave. Analyzing the results of Amazon.com, the Internet retailer, they wrote:

“There was one aspect of the [Amazon financial] report that received little attention. While the company’s earnings yield based on 2007 EPS forecasts is a meager 1.6%, one area where the company has had an amazing return on investment is stock repurchases. Since August 2006, the company has spent $500 million buying back 14 million shares of its stock (approximately 3.4% of outstanding shares). … Those 14 million shares which the company spent $500 million buying back are now worth $868 million for a profit of $368 million in less than a year (73%)! To put that number in perspective, the unrealized profit on the stock buybacks is nearly twice as much as the company made all last year.”

So, lets get this straight.

Amazon.com spent $500 million dollars in canceling its shares, taking them off the market. It now has $500 million dollars less than it had before the stock buyback. There are no assets received as a ‘quid pro quo’ for this disbursement of $500 million dollars. They didn’t ‘buy’ anything with this money. The remaining shareholders have a larger percentage of a company with $500 million less in cash.

Even though the price of Amazon.com shares went up after the buybacks, the company did not benefit from this at all. It had no ‘assets’ that increased in value, producing an ‘unrealized profit’ of $368 million. (This truly was an ‘unrealized profit’ in the absolute sense.)

Now, I really don’t want to pick on Hickey and Walters. If fact, their way of analyzing the market seems to be quite common at this stage of the Buyback Bubble and, for all I know, they may have been taught this type of analysis in business school.

I wrote an essay on “The Great Misleading” that spoke of buybacks as “frauds so well conducted that it would be stupidity not to be deceived by them”, dealing with the clever arguments of those promoting buybacks during the 1990s. Today’s feverish articles extolling buybacks are not as sophisticated in their reasoning as those of a decade ago.

This is just another sign of the advanced stage of the buyback sickness that has caught up so many.

Now, I’ve reported for some time (as many articles on this site attest) that buybacks have been driving the price of stock upward since the mid-1980s. Until the last year or so, however, most investors (as indicated by press reports) seemed unaware of this.

With Google Alerts, my email brings the news that things have changed:

• The fact that buybacks are forcing stock prices upwards is now widely known, accepted, and (mostly) applauded;

• The contention that price and value are equivalent has become conventional wisdom; an increase in stock prices due to buybacks is considered as boosting the intrinsic value of investors’ portfolios;

• The combined effect of private equity plays and buybacks reducing the supply of equities is considered a good thing and healthy for investors’ well-being.

A few years back, the fact that buybacks were driving the market had not yet become common knowledge —this has now changed.

But wait, my ‘Googlemeter’ brings more news:

• Corporations, in the aggregate, no longer have enough money to pay for stock buybacks out of cash reserves; they must borrow from banks to keep stock prices in the air. (This is confirmed by the Federal Reserve flow of funds accounts for the last year);

• Rating agencies (never fast to condemn doubtful practices) have begun to downgrade the bonds of companies that are financing buybacks with borrowed money;

• Banks are giving signals of reckless behavior (as they do from time to time, such as with margin lending in the 1920s, loans to Enron and Long Term Capital Management in the 1990s, and sub-prime lending recently) loaning money to finance buybacks — essentially giving depositors’ money (through the ruse of buybacks) to speculators who will never pay it back — and regulators, as usual, are unsure of what this all means.

Evidence that the investing public accepts this state of affairs is a sign that the market is in an advanced stage of its speculative fever, and that this, combined with indications that the market is over-priced in terms of dividend returns, portends that our patient will eventually swoon and fall to the ground.

The question is: when will this happen. (In other words, “Please daddy, can’t I stay in the market a little longer?”)

Waiting for someone to bite the tulip bulb

Folk tales of the speculative tulip mania in Holland in 1634-1637 circulate freely among Wall Street bears, along with the story of the (perhaps mythical) sailor who bit into a bulb, thinking it was an onion, thereby bringing reality to the market and crashing tulip prices.

Now, I have been working in capital markets for over two generations and have observed market psychology in booms and busts at first hand. I’ve also tried to warn clients in time to get out of dangerous markets in time and know by now that such warnings are generally unheeded.

The problem is that, although the signs of impending doom are there for all to see, no one can predict exactly when doomsday will come — tomorrow or two years from now —and investors want to hang on until the last possible moment.

I, for one, don’t know when the sailor will bite the tulip bulp.

The Look and Feel of the Top of the Market

Except in special circumstances, like the Crash of 1987, the end of a boom doesn’t usually happen on a single day. Here’s how the end will probably look and feel:

• On a certain day, prices will start down, perhaps sharply, but then recovering somewhat at the end of trading. The talking heads on Neil Cavuto’s show will scream at each other: it’s time to buy; stocks are now cheap. Neil himself will say calmly, “I have great faith in American businessmen and women.”

• The market will continue to back and fill, trending downwards. Investors will say, “Perhaps if the market gets back to the recent peak, I’ll sell a little.” The market probably won’t oblige, and, even if it does, investors will forget to sell.

• After the market has fallen considerably, say 20%, brokers will undertake a massive campaign to ‘reeducate’ investors, saying “We’ve now hit bottom”. Professors from Ivy League colleges will be hired to attest that stocks are indeed cheap, by all the laws of ‘economic science’. Wall Street will remind the public of how those who have held fast have always done better in the long run. Investors, never anxious to sell, will be convinced and will continue to see their portfolios erode.

In other words, the best time to get out of the market is right now — before the crash. Sure, you will miss some capital gains as the market continues to move upwards and your friends, still in the market, will look at you as a fool, but you’ll have converted already over-priced stocks into hard cash while it was still possible to do so.

It’s hard to sell now, while the party is still in full swing, but it will be even harder when the market crashes and you carry the psychological burden of actual losses.

But of course, few people will follow the course of prudence. That’s what speculative bubbles are all about.

As described in the article “US Equities: Wildly Over-Priced or a Great Bargain?“, the half-trillion dollar annual buyback craze that rules American equities has caused a gap to open between the value of equities held for the long-term and value to short-term speculators and those living off unrealized capital gains (like managers of open-end mutual funds).

The reason for this divergence in value is simply that cash paid out for buybacks does not go to long-term stockholders, but instead to corporate executives and short-term speculators.

As shown in the Price-PATAB chart in the article, stocks for the long-term have half of the value they would have if buybacks were paid fairly in the form of dividends.

Private Equity Steps into the Arena!

To take advantage of this divergence of values, vast amounts of money are being borrowed to take companies private. Once a company is private, control is transferred from hired-executives and fund managers into the hands of permanent shareholders. Corporate cash that was being diverted into buybacks can now go directly to shareholders, rather than executives via stock options or to short-term speculators.

Free from ineffective meddling by the SEC and the annoyances of Sarbanes-Oxley, private shareholders can now take control of corporate cash that was being channeled into buybacks, using what was to be buyback money to pay off loans that made the private-equity play possible — in essence, using the company’s own funds to take the company off the market.

Using corporate cash to acquire control, of course, is nothing new. What is different in the private equity movement is that cash dividends have fallen out of favor (See: “Harvard’s Breakthrough Idea: Don’t Pay Dividends!“), and buybacks now dominate the equity market (See: “Corporate Buybacks Continue at Record Levels: Q2 2006“), making it easy to find targets for private-equity-buyback arbitrage.

Private-equity plays are also different in that it is not really necessary to “clean up” a company, undertaking risky reform or restructuring, before putting it into the market again. The key is simply to divert buyback money to pay for ownership and then sell for a profit — essentially a form of slow motion arbitrage.

Of course, the booming trade deficit helps and is essential — money pouring in from abroad keeps interest rates low in the bond market and makes private-equity deals feasible. (See: “Hugo Chavez: The US Bond Market’s Friend“).

Will Private Equity Kill the Buyback Movement?

There is no reasonable doubt that most stock buybacks are unethical and fraudulent (See:”Stock Buybacks, Dividend Equivalency, and Securities Fraud“) and that these buybacks have been the driving force in the US equity market since the mid-1980s.

The question, however, is what will it take to bring the buyback movement to an end? Over the last few years, in this blog we’ve considered various possibilities:

• Companies might run out of cash: Up until the market crash of 2000, it seemed that the buyback movement might end when companies no longer could generate the increasing amounts of money needed to continue to force prices upwards with buybacks. However, good economic times stemming from the Bush tax cuts, plus surprising corporate willingness to raid depreciation reserves and borrow to keep buybacks going, have driven buybacks to levels that seemed unimaginable in the pre-2000 years.

• The government might step in: There was never much chance that the SEC or Congress would do anything meaningful to protect long-term shareholders from the plundering of buyback pirates, unless there was a major market crash, on the order of 1929 — an even then, probably not.

• Lawyers and the courts might take action: Because buybacks are likely to shelter criminal activity, especially stock fraud, there is always the faint chance that the creaky US justice system might start to work against corporate executives and stock buybacks, sending a chill that will discourage the practice. (See:”Buybacks + Options + Hedge Funds + Inside Information = Crime?“)

• Public opinion might turn: In the last two years, there has been growing criticism against buybacks, something almost unheard of prior to the crash of 2000. However, the Wall Street propaganda machine and the outright purchase of Congressmen and women, means that any progress along these lines would be a long hard slog. (See: “Investor Alert! Sarbanes Oxley Will Likely Be Gutted in 2007“)

• Company executives might suddenly get an attack of morality: There was never much chance of this — not as long as the Harvard Business School continues to sponsor ethical ambiguity. (See: “Jeff Skilling Tells the Truth about US Corporate Ethics“).

• Pressure from foreign new issues on the US equity market: Prior to 2000, this was an important consideration and, in fact, it was a major factor in the crash of 2000. However, Sarbannes-Oxley plus the growth of international markets has served to curb non-US corporate enthusiasm for issuing equities in the US.

The private-equity-buyback arbitrage play is an entirely new threat to the buyback movement, with greedy motives and massive funding giving reason to believe that this may, indeed, be the beginning of the end for buybacks.

Greed vs. Greed: A Winning Combination for Ordinary Investors

As long as executives try to use excess corporate cash and buybacks to push up their stock prices and give value to their options, they will be juicy targets for private-equity-buyback arbitrage.

Old line Wall Street firms, like Goldman Sachs, can not be happy with this new development, because any reduction in buybacks cuts off a valuable stream of income from SEC Rule 10b-18 and diminishes their profits — but, don’t worry, they will adapt. Moveover, relative newcomers, like the Blackstone Group are set up to feed off private-equity-buyback arbitrage and are raring to move into center stage. Just as Donaldson, Luftkin, Jenrette shook up the institutional investment market in the 1960s, the private-equity movement signals a major change in the market of the early 21st century.

Meanwhile, what will hired corporate executives be doing, once they wise up to the threat that private-equity-buyback arbitrage represents to their personal financial interests? From their point of view, a take-over is a take-over — someone else is going to call the shots and they won’t be able to put that Olympic swimming pool into their corner office after all.

So how should the smart hired corporate executive respond to this threat. Well, the answer is easy: start paying out buybacks in the form of cash dividends, fairly to all shareholders.

This would would raise current yield dramatically, driving up stock prices and eliminating the value discrepancy. It would give value to executive stock options, give cash to long-term shareholders, and reduce the potential for private-equity-buyback arbitrage. Last, but not least, corporate executives — for the first time in a generation — would be able to claim the moral high ground of actually paying dividends and high yields to small shareholders and retirees.

With corporate executives switching to big-dividend mode, for self-protection, and with private-equity gangs roaming the market seeking out unenlightened troglodytes who insist on buybacks and small dividends, the general level of stock prices should rise nicely, thank you — as long as the trade deficit continues to provide funds to finance this gigantic arbitrage play.

So maybe, after all, Gordon Gecko was right: Greed is good. The market will heal itself. Even the small investors might win.

At least until the Democrats manage to lose the War on Terror and New York City vanishes under an atomic blast. (See: “Victory in Iraq is not an Option — for the Democratic Party“)

Many equity investors are not nearly as well off as they think — unless they are in the process of selling out today to invest in fixed income securities and a widely diversified portfolio of real estate income properties.

The question that long-term investors should be asking is how much do they risk losing by continuing to believe in the Common Stock Legend and the advice of their stockbrokers?

In the roar of Wall Street cheering about good times for equities, the chances that most equity holders will ask sensible questions about market values in time to save their assets is remote.

And, if and when they should ask, it will certainly be too late, because stock markets are not designed to withstand a rush for the exits.

Quantifying the downside risk in equities

It is possible to find serious researchers at prestigious universities and financial experts with articles in the Financial Analysts Journal that state that a fall of 30% to 50% from current market levels would be required for US equities to be ‘fairly priced’.

This means that that wealth held in US equities is probably over-valued by $3.3 trillion to $5.5 trillion! A readjustment to fair value would be painful, with serious economic and political consequences.

See: “Are GAO Projected Returns on Equities Reasonable?“

Most investors do not have the time, inclination, or skills to plow through the technical literature to find out whether stocks are over-priced. And the SEC will not help them.

However, investors do not need to rely on articles in Money magazine (supported by ads of Wall Street firms), or the Quicken ‘retirement planner’ (based on assumptions that the past predicts the future), or even on their stockbrokers (who earn a living by selling common stock and equity mutual funds).

By using common sense and some easily available statistics, John Burr Williams’ famous formula for equity valuation allows investors to check for themselves whether US equities, in general, are fairly priced or not.

As John Burr Williams pointed out seventy years ago, the sensible reason for long-term investors to hold common stocks is to receive a future stream of dividends paid by the company.

To build up wealth for their retirement, investors should put aside enough current income to provide for their old age, reinvesting dividends and interest received in the interim.

A prudent retirement plan: the essentials

No one can predict what the marketplace may be willing to pay for equities twenty or thirty years from now, when today’s retirees will need to sell investments.

However, with the anticipated crush of Baby Boomers needing money for assisted living and health care ten to twenty years from now, chances are good that ‘reinvesting unrealized capital gains’ in the hope of selling out many years from now is, at the very least, unwise.

A sound retirement portfolio is one that will throw off a dependable stream of cash dividends and interest, not only to provide income decades from now, but also to provide substantial current yields at that distant date so as to ensure that the value of a retirement portfolio is supported by cash payouts, so that, if it is necessary to draw down on the principal, the portfolio will be fully valued by the market.

Why US equities are 40% over-valued today

Here is how an investor might evaluate the level of US equity prices, based on John Burr Williams’ formula:

See “The Value of Dividends” for an explanation of John Burr Williams’ formula.

In other words, given the S&P 500 rate of growth of dividends on US equities over the last twenty years, and popular expectations of return from long-term portfolios of common stocks (about 8%), equities, on average, seem to be over-priced by about 40% based on the current value of reasonable expectations of the future stream of dividends.

Considering that the annual growth of before tax US corporate profits over the long-term (1946-2003) was only 5.3%, predicting growth of corporate dividends at 5.5%, based on the S&P 500 dividends from 1985 to 2006, certainly does not seem to be overly-conservative.

So the two numbers needed for John Burr Williams’ equation, the 8% return expectation of investors and a 5.5% growth rate for dividends, seem to be quite reasonable.

Therefore, a drop of about 30% in stock prices would be required for equity investors to get the 8% return most expect when planning to fund retirement goals.

Corporate reform could dramatically improve equity values

Although, as indicated in the article “US Equities: Wildly Over-Priced or a Great Bargain?“, corporate earnings before buybacks are soaring to record levels, a huge multi-billion dollar chunk of this money is being diverted to the benefit of corporate executives rather than long-term shareholders.

If Corporate America were to suddenly reform, putting brakes on executive remuneration and redirecting buyback payouts into cash dividends, paid out fairly to all investors, then, indeed, Wall Street ballyhoo would be justified. Equities would be fairly valued and ordinary investors would be adequately protected.

However, since buybacks and corporate greed seem to be embedded in Wall Street culture, any investor who is willing to bet his or her retirement comfort on a sudden change of heart and sincere reform of rapacious executives, may deserve to be taken to the cleaners.

Expect continued irrational behavior

As pointed out in a previous article, if US corporations were to change their behavior, eliminating stock buybacks and using the money instead to pay dividends fairly to all shareholders, US equities would indeed by fairly priced and most retirement plans would be on track.

However, don’t hold your breath until that happens.

Uncontrolled, self-serving behavior of corporate executives taking advantage of an accommodating and dormant SEC and the unquestioning belief of the investing masses in the Common Stock Legend suggests that current patterns are likely to persist and that, therefore, US equities will continue to be substantially over-priced — until the next crash.

	Two ways to see things

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:

	Corporate profits, adjusted for buybacks

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.

	Price-earnings ratios: with and without buybacks

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!

	If buybacks were really dividends ...

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 acco