Buyback Bubble Pops! A long way down

Reading time: 6 – 9 minutes

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 buyback bubble can't last forever ...

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.

What the July credit crunch bodes

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

Corporations buyback stocks

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 the approval of fund managers who control executive remuneration and who are 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.

Executives exercise options

Corporate executives have been vigorously selling equities to take profits on stock options while prices are high.

For over a generation, stock sales by individuals (mainly corporate executives) have exceeded purchases by a wide margin — recently more than one trillion dollars every 18 months.

Fund shareholders are satisfied

Ignorant of how markets work, unsophisticated fund shareholders have continued to invest in equities, lulled by SEC-approved Total Return statistics (inflated by unrealized capital gains, the result of massive corporate buyback programs) and by fund marketing ballyhoo.

These investors generally have been unaware that buyback money does not go to them, the owners of corporate America, but to employee-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 gigantic Ponzi scheme

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

As stock prices rise, it takes ever more buyback 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 manipulating prices upwards.

To raise money for buybacks, dividends must be cut, earnings diverted, 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.

A rush to the exit

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, when 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!