Stock buybacks dry up

Reading time: 6 – 10 minutes

The fourth quarter of 2008 is known for the international banking crisis which will lead to dramatic changes in financial regulation and to massive de-leveraging of institutions.

Is the buyback party over?

Generally overlooked in the current analyses, however, are indications that the stock buyback era that began in the early 1980s, may have finally come to a sudden and violent end.

It appears unlikely that equity markets will be the same going forward.

Most on Wall Street do not remember what equity markets were like before buybacks and stock options became dominant.

A dramatic reversal

Fed flow of funds tables reveal what happened

By comparing the net flow of funds in the US equity market from Q4 2007 to Q4 2008, we can see how the equity market has changed:

US Corporate Equity Net Flow of Funds (yearly basis)

The figures for Q4 2007 show the typical pattern of the equity market during the buyback era.

The market was dominated and driven upwards by massive stock buybacks, with wealth being transferred to corporate executives holding stock options — in this case to the tune of over one trillion dollars a year.

This transfer of shareholder wealth from corporate treasuries to a company’s own executives, to the detriment of ordinary shareholders, has been going on for twenty-five years.

Recently, however, corporate executives were not satisfied to simply pass corporate profits on to themselves by means of stock options, but went even farther — borrowing from banks, using corporate credit, to raise funds no longer found on the yearly profit and loss report.

The extreme credit squeeze and the collapse of equity prices in Q4 2008, brought the buyback-option scheme to a well-deserved end.

As the table shows, individuals ( mainly executive option holders), no longer were exercising their options.

A trillion dollars in option executions disappeared from one year to the next. Prices were too low and, in the midst of this crisis, even these executives were not brave enough to quickly write down their option terms.

Even so, in the midst of a crashing market, corporations still managed to get off $450 billion in buybacks — of which only $92 billion was available from profits, after taxes and dividends — the rest was borrowed from banks that were supposedly hard up for cash.

Why this is may be  the end of an era

For the last few years, corporations have come to depend upon borrowing from banks in order to keep the buyback bubble in the air.

Now, however, with the dramatic collapse of large Wall Street firms, a period of long-term de-leveraging has begun.

It is unlikely that money will be available to finance buybacks on the scale needed to drive prices upwards.

The second problem for buybacks is also indicated in the above table.

The government is now the major player in the market, putting over one trillion dollars into financial equities in Q4 2008.

This massive diversion of taxpayer funds has been accompanied by a hue and cry against “greedy executives” and “excessive remuneration”.

Someone must hang

People have lost a lot of money on Wall Street and are looking for someone to hang.

As I have pointed out, repeatedly — to the point of being boring — on this blog and the accompanying website, the whole stock-buyback-option deal has been a massive fraud upon ordinary shareholders.

I’ve been railing against buybacks for a decade now.

In the 1990s, few criticisms of the practice could be found in the press.

Even five years ago, the words “buyback” and “fraud” were rarely linked. Today, however, just google “stock buyback fraud” and you’ll see how public opinion has changed.

What is needed for buybacks to resume

For the buyback movement to get going again, corporations must have cash available, investors must be ignorant of what is going on, and most importantly, buybacks must be effective in driving up stock prices.

Before “good times” for buybacks can return, several barriers must be overcome:

1. Investors must be willing to hold their positions and not sell into major rallies. However, Baby Boomers are beginning to enter their “golden years” and having lost half of their old age money, its seems likely that they will be eager to get out of equities entirely, as soon as prices begin to recover. This pent up supply of sellers is not good news for buybacks.
2. The country is in the midst of a severe recession (perhaps a depression). Corporate profits are down. This means that internal sources of funding for buybacks have dried up. At the same time, credit is difficult. Buybacks need money, in massive amounts. From the above table, we see that a trillion dollars was needed to keep prices up in 2007.
3. The government is definitely not as friendly or indifferent to buybacks as has been the case in the past. Public opinion is against high levels of executive remuneration and is likely to remain so, as long as the government is involved in investing in public companies.

The world without buybacks

The US capital market will be dramatically different without stock buybacks.

Its necessary to go back to 1967 to get an idea of what a world without buybacks might be like.

One thing seems certain: without buybacks, the volume of trading will be much, much less.

Brokers will make less money. The market will shrink. Less people will be employed on Wall Street.

Just look at the table for Q4 2007 and Q4 2008 and you’ll see what happens when a trillion dollar player leaves the casino.

The position of government

Now, on top of everything, imaging the new trillion dollar player (the US government), also getting out of the market.

What’s left is a market that simply will not support as many financial professionals and auxiliaries as in the past.

Another change to be expected is that it will be far more difficult to manage mutual funds without buybacks to drive prices up year after year.

Analysts will have to get out Graham & Dodd and start doing research to find undervalued opportunities.

Way back in 1967, before the buyback era, stocks were traded on the basis of dividends, at much lower price-earnings ratios.

It is unlikely that the market will go back to 1967, but instead, forward, to some new paradigm which is not yet discernible.