A Rally Without Investors And Other Musings

clokey's picture

Over the course of the last two weeks, I attempted to explain to the general investing public how, thanks to the virtual impossibility of distinguising between 'legitimate' market making and 'illegitimate' prop trading, some of America's systemically important financial institutions are able to trade for their own accounts with the fungible cash so generously bestowed upon them by an unwitting multitude of depositors and an enabling Fed. Of course, as I noted recently, simply taking excess reserves and using them "to make big bets in the credit and equity markets would be too transparent even for U.S. regulators," so the banks do what any scandalous business worth its salt does -- they launder the money. The laundering services are provided by the Bank of New York Mellon, State Street, and JPMorgan -- in other words, the custodian banks. Through repo channels, banks are able to pledge the assets they purchased with deposits and excess reserves as collateral for 'clean' cash. The best part? The pledged assets stay on the books even as the cash loans are 'invested' in such bastions of capital preservation as Markit's CDS indices and, of course, equities. 

As it turns out, the investing public doesn't take kindly to the idea that their deposits and their tax dollars (via the Fed's Treasury purchases) are being used as poker chips. Apparently, they have been slowly indoctrinated by the incremental doses of Keynesian propoganda they receive each time they turn on the TV or read the main stream financial press. As such, they are decidedly unwilling to admit that the glaring contradiction between ICI data which shows some $130 billion in net outflows from domestic equity funds in 2012 and an S&P 500 index hitting all time highs, might just signal that the market is being propped up by something other than good old, healthly grassroots demand from retail investors.

Commentators generally write-off the mutual fund flows data by asserting that the reason for the apparent exodus is retail investors' newfound preference for ETFs. This is a nice thought but unfortunately, it isn't supported by the data. The following chart shows that even when ETF flows are taken into account, there was a net outflow of some $21 billion from U.S. equity funds in 2012:

So given this, where has the money come from that has sparked the rally? One answer is that excess liquidity pumped into the coffers of the primary dealers by the Fed combined with a historically low (72%) loan-to-deposit ratio has precipitated a prop trading field day at some big banks. This contention is supported by Goldman's latest quarter which showed that between prop trading (they call it 'principal transactions') and market making, the firm pulled in $4.7 billion in revenues in just three months.

But aside from this, there is another channel by which the Fed's actions have driven stocks higher. The magic of ZIRP has led to historically low corporate bond yields fueling a flood of corporate issuance in 2012. The problem? Corporations aren't borrowing to invest in their businesses per se, they are borrowing to buyback their own shares. Put simply, when you can borrow for less than the cost of paying dividends, why the hell not borrow and buyback some shares? Even the Wall Street Journal gets it:

Some of the spending on buybacks is just financial tinkering -- interest rates on borrowed money are cheaper than paying dividends, so companies take on more debt to eliminate some of their shares.

So just how much of the market's 2012 gains can be attributed to corporate buybacks fueled by ZIRP? Have a look at the following chart which shows that some $405 billion was spent in 2012 on buybacks, the most since 2011 which, in turn, was the most since 2007:

It would certainly seem then, that with retail investors being net sellers, the stock market rally can be entirely attributed to corporate share buybacks, in conjunction with prop trading at cash-flush, repo-pyramiding banks.

This isn't a good sign for two reasons. First, note the similarites in the following chart regarding the trend in the percentage of corporate cash spent on share buybacks in the years leading up to 2007 and in post crisis years:

A rising percentage of corporate cash usage devoted to share buybacks is not generally a good thing. In fact, it may well be appropriately viewed as a contrarian indicator given that corporations can sometimes be pitiful judges of value in terms of when the right time to buy is. Take Intel for instance which

...over the last 10 years has spent about $56 billion to buy what is now $52.5 billion of stock. Counting the dividends Intel didn't have to pay, the company's return on investment from these purchases was roughly zero

Furthermore, companies are fond of saying that buybacks are a way of returning cash to shareholders. Of course, if the buybacks are funded by the accumulation of debt (even at low interest rates) it isn't exactly accurate to say that any cash has been 'returned.' Take for instance, Herbalife who, in the second quarter of 2012 trumpeted a new 5-year, $1 billion share buyback program. The company said it would fund the program with future earnings if possible but suggested that it may fund the repurchases with a new credit facility. The new credit facility was necessary because the old revolving credit facility was used to...wait for it.... repurchase stock. As I noted at the time, 

the new credit facility is being used to pay-off the revolver on the existing credit facility which was itself used to buy back shares. Essentially then, the company took out a loan to buy back the
shares, then took out another loan to pay off that loan, and now says it may ("if needed") use the remaining balance of the new loan to buy more shares. This doesn't sound like "returning excess cash flows to shareholders" to me. It sounds like returning other people's money to shareholders and incurring debt obligations along the way which, of course, the company must pay interest on in the mean time.

Aside from all of this, there is another problem. Corporations are so busy buying back shares in order to artificially boost earnings (remember, when shares are repurchased the denominator in the EPS calculation shrinks) they have neglected to make the requisite expenditures on that all-important source of productivity and efficiency: capital. If you're buying back shares you're not investing in productive capacity and while you may be helping to keep the stock market afloat with share repurchases, you're virtually assuring that your company will be less competitive in the long run. In short, it isn't any coincidence that share buybacks are up while capex is down or flat as a percentage of corporate cash usage. 

So for those poor souls who have had their ability to connect the dots blunted by the deafening chorus of the Keynesian establishment, allow me to reiterate: there are no coincidences here. It isn't mere happenstance that stocks are somehow at five year highs despite net $21 billion in retail outflows from equity mutual funds and ETFs during the previous twelve months. ZIRP-fueled corporate borrowing has funded capex-killing share buybacks. Meanwhile, record deposits over loans combined with the endless stream of freshly printed dollars flowing into the accounts of primary dealers has meant a bonanza of fungible dry powder for big banks. Once this cash is recycled through repo channels, it finds its way into every corner of the market even as the repoed collateral sits on the books like trophies on a shelf waiting to be admired by regulators and clueless investors alike. A centrally planned market for a centrally planned world. 

Charts: Goldman 

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geno-econ's picture

Why aren't government regulators, economists and policymakers following these trends and pointing out the consequenses ?  Don't tell me , I already know the answer. Something to do with Ponzi and keep the good times a'rollin.  Besides we are all participants and guilty by association one way or another. Anybody got a better idea of how to bring us to our senses ??

Shizzmoney's picture

So the OP is just saying, in essence: Corporate Buybacks are just one huge ponzi scheme.

Well, damn.  My company does this as well........when that other shoe drops, it's going to be one hell of a bloodbath.

DeadFred's picture

Sometimes I think I have learned quite a bit from my last couple years on zerohedge then I come across another one of those terms I don't recognize, Retail Investor?


marz929's picture

Very good article. Had a lot of answers to questions that had occurred to me over the past several weeks when I heard this data discussed in the MSM. Thank you for posting!

orangegeek's picture

We are on the cusp of new historical highs in the Dow and SP500.  47M Americans on food stamps.  Labor Participation Rates at historical lows (makes unemployment rate look acceptable).  Personal taxes going up with a promise to continue to increase them.




And the MSM calling this a fragile recovery.  Smells like a crash never seen before in history. 

Cheyenne's picture

"Smells like a crash never seen before in history."

Agreed. And the article points out that an important predicate for this ramp job is very low rates. And what's enabling these? Why, the same fraudulent insurance scheme that busted out in 2008, only on a much larger scale.

Courtesy of Tyler on 4/16/11:

"[T]oday we learn that to keep long rates low, the Fed may have resorted to nothing short of the same suicidal trade that destroyed AIG FP and brought the entire system to its knees. Namely, Ben Bernanke is now quite possibly the second coming of Joe Cassano, since in order to keep rates low, Bernanke is forced to a last resort action of selling billions upon billions of Treasury puts to "pin" rates low contrary to natural supply-demand mechanics."



GMadScientist's picture

Bravo; great article!

rsnoble's picture

I wonder when Obama will say "Now looks like a good time to short stocks"?? LOL.

Oldwood's picture

WallStreet will never rest until we are "all in", one way or another. The question is what then? There is only one way to stop it and that is to get "all out". No banks, no stocks, no bonds. Of course we would likely be precipitating our end, but I think it inevitable regardless.

Winston of Oceania's picture

I think it would take no more than perhaps ten percent of the people decoupling from the rotted system to crash it now.

Cult of Criminality's picture

.....      ........     . . . .....      Ding!

Good Job

Dr. Sandi's picture

Ballsy tie-in. My hat is off to you on that one.

luna_man's picture



Regardless, I stay "short"!...I sense, it's coming my way.

cliffynator's picture

Me too.. but I sure hope it pays off soon! I'm getting tired of watching my short capital get decimated by the Gap & Ramp show put on by the World Central Bank Championships every week.

dunce's picture

I worked at a company that issued bonds in a profitable way. They wanted to completely rebuild the plant so they stonewalled the union at contract expiration and they went on strike, then they brought in contactors to rebuild the plant, finally they settled with the union and got them to agree to profit sharing. They had issued high yield bonds to the parent corporation so debt service used up all the profits. I started a few years  after the whole deal was over much of the debt had been retired  and my checks had profits shares. Interest is deductible as  an expense and dividends are taxed. I never looked into tha finances of the parent but it is controlled by a Texas billionaire

steveo77's picture

Deflationistas versus the Inflation crowd 
I posted this survey, which is mostly meant for entertainment and to try out the new "Survey Monkey" which is free html that I added to the post. So far it seems like a great service. 
Here is the Survey, visit and log your opinion. It takes 2 minutes. 
http://oahutrading.blogspot.com/2013/01/deflation-or-inflation- survey.html  
Here is the first day results 
http://oahutrading.blogspot.com/2013/01/deflationistas-versus- inflantion-crowd.html

GMadScientist's picture

Stagflation: why choose?

The rampant deflation of high UE combined with pointless nominal chicanery and subsequent inflation of input prices.

Dead Canary's picture

Soooo....... I keep buying silver, right?

(Just checking)

Dr Benway's picture

Great article.

And after companies ramp their own share price with buybacks, in the process benefiting executives that have shareprice-based remuneration, they can then trumpet a capital raising from gullible investors at the ramped price, thus leaving the number of outstanding shares unchanged (or higher), thus precluding the theoretical gain to investors due to retired shares.

Even theoretically share buybacks do not actually return money to shareholders, they return money to those that sell their shares, i.e. ex-shareholders.

Pemaquid's picture

That would be me. Isn't life grand!

Joe moneybags's picture

Let's put this "no volume behind the rally" idea in context.  The major U.S. market indexes, as well as most all world stock indexes, have been in a rally mode, most about doubling, for the past 3 years and 10 months.  During that time, we have been treated to articles such as this, pointing out low retail volume.  So why now, will this low retail volume be relevant?  Obviously, there are many other factors in play, which counteract the lack of interest by Suzie Soccermom.

otto skorzeny's picture

let's not forget that every dollar you "save from the evil clutches of Wall St" by putting it in a .15% savings account at the TBTF banks are invested by them in equities anyway. basically the only way to prevent this is by putting it in the Bank of Serta or Stearns and Foster. also-I've seen some dicked up stuff in the "markets"  but VIX is cra-zy.

donsluck's picture

Or PMs, or real estate (I don't recommend), or work less (I recommend). Say no to paper of all kinds.

DoChenRollingBearing's picture

Barron's this weekend noted that most stock indices hit new highs...  And their Roundtable investment pros are at it again, making their predictions.  They averaged some 12% (or so) vs. the S&P 500.

Review of Barron's:


lunaticfringe's picture

Thank you. I am a dullard who has been rubbing his head lately and asking, wtf? Now I get it.



French Frog's picture

ZH's primary role: education about the financial markets backed by facts since 2009 (aging nicely like a good wine).

SafelyGraze's picture

compare and contrast:

corp buying up all its own shares

animal eating its own poop

at some point you gotta eat someone *else's* poop if you hope to grow big and strong

GMadScientist's picture

Not if your goal is to exercise your poop options and poop parachute leaving others to clean up the poop.

IBGYBG (I'll Be Greek You'll Be Greek!)