Foreigners and funds buy US stocks

Reading time: 9 – 15 minutes

Mutual funds and foreign investors were the driving force in the bear market recovery of 2009. The generation-long pattern of buybacks and stock options had dissolved.  However, the modified behavior does not seem stable — it is not yet a ‘paradigm shift’.

There are a number of formidable barrier to a continued rise in stock prices, but a ‘Wall of Fear’ does not seem to be one of them.

Relevant statistics from Federal Reserve flow of funds accounts for Q3 2009 are as follows (Federal Reserve Release Z.1, Table F.213, Corporate Equities):

Pre-1982 patterns are back

Prior to the issuance of SEC Rule 10b-18 in 1982, US equity market operated as described in Economics 101:  Issuers came to the stock market to raise capital by selling equities; investors bought this stock primarily to receive future dividends that were often higher than the interest on bonds of comparable companies.

Market clockwork from former times

The price of stock was determined by forces of supply and demand: when stock became expensive (and dividend yields low), companies would rush to take advantage of the low cost of capital by floating stock.

When stock prices fell and dividend yields rose, investors would rush to buy and issuers refrained from selling stock.

This is the pattern that we see again in Q2 and Q3 2009:

• Stock prices were rising, as households, mutual funds, and foreign investors bought equities. (The table shows this net amount in Q3 2009 to be in excess of $460 billion on an annual basis);
• Corporations (both non-financial and banks, domestic and foreign) took advantage of investor interest to sell equities, spurred on by the credit crunch and need to de-leverage.  (The table shows that net flows of this type exceeded $300 billion on an annual basis in Q3 2009.)

Because of the perception that stocks were cheap following the Crash of 2008 and investors’ anxiety to find a safe place for money in anticipation of inflation, the motivation of  buyers was stronger than that of issuers to sell — prices rose.

However, yields on stock dividends are still lower than on bonds of comparable issuers.  It’s not the 1970’s yet.

The end of stock buybacks?

If we compare the flows in US equity markets in Q3 2009 with those of the year 2007, we see a radical change in behavior.

In 2007, as had been the pattern since 1982, non-financial corporations and banks were buying back their own stocks — in this case about $800 billion (net annual rate)  — in order to force prices upwards.

At the same time,individuals (reported in the household sector) were selling about $800 billion in equities (net annual rate) that had been acquired mainly through executive stock options —  realizing a handsome profit.

In 1982, the US SEC Commissioners carried 'deregulation' a bit too far, granting issuers safe harbor from manipulation on stock buybacks by Rule 10b-18.

Because executives were on both sides of the market  — as managers of the corporations ordering the stock buybacks and as individuals, exercising options on stock which they had granted to themselves — prices were manipulated upwards to maximize executive profits ( but not the profits of long-term shareholders).

This unethical behavior had been going one for a quarter of a century, under the benevolent and distracted gaze of the US SEC.  See the many articles on stock buybacks on this blog for a full discussion of the buyback era and the fraudulent aspects of this practice.

The buyback era came to a halt with the Crash of 2008.

Companies were no longer able to borrow money in the ever greater amounts needed to force up prices of their shares.

A shortage of funds forced corporations to halt buybacks.

However, so far, there has been no mass repentance or condemnation of stock buybacks.  Many, who should know better, still don’t get it.  Unless the matter in broached together with general market reforms, the practice may indeed return in better times — to the disadvantage of long-term investors.

Historical Note: There is no indication that the SEC Commissioners in 1982 were aware of the long-term consequences of Rule 10b-18 that set off the ‘Buyback Era’. In fact, the impact of buybacks on equity prices went largely unnoticed for years, because few were looking at the Federal Reserve Flow of Funds Accounts. One of the commissioners at that time, John R. Evans, was a good personal friend . When we discussed the implications of stock buybacks in the late 1990s, he was as surprised, as was I, that the equity market had been so distorted.  At first we did not realize that the cause was Rule 10b-18.

Unsophisticated investors?

In Q3 2009, sophisticated investors — like insurance companies and private pension funds — seemed to have less interest in equities.  In the case of life insurance companies, equity purchases were running about $70 billion less (net annual rate) than in 2007, before the Crash of 2008.  Private pension funds were still selling, possibly indicating the effect of the aging of the Baby Boomers.

Ganesha, the Hindu god of Wisdom, may open doors, but not all walk through.

In contrast, mutual funds were buying heavily.  We know (from surveys by the Investment Company Institute) that although managers of mutual funds may be sophisticated, many of their shareholders are not.

When people buy mutual funds that are advertised as having equity-oriented investment policies, fund managers must buy equities, whether they like it or not.

From flow of funds during the Crash of 2000, we observed that foreign investors were still buying US equities, when insurance companies were getting out — a suggestion that foreign investors in US equities may also be behind the curve, although the reasons why this might be so are not as clear.

(See: Case Study of the Crash of 2000.)

Obama’s manipulation?

On the other hand, these ‘foreigners’ may be hedge funds located in offshore financial centers.  Some observers have suggested that the Obama administration may be manipulating the stock market upwards, for political reasons — but the flow of funds data does not offer proof of this.

Conspiracy theories are not needed to explain the Bear Market Rally of 2009.

The flow of funds data does indicate that the Federal government was buying equities at an annual net rate of $53.7 billion, while state and local governments were selling a similar amount.

This could be an indication of the administration’s desire to stabilize stock prices, although, again, the Fed data does not provide the details.

In any event, it is clear that the Federal government’s involvement in the equity market has been aggressive and is far different from pre-Crash ‘non-involvement’ policies, indicated in the flows for 2007.

The reduction in broker-dealer equity

The flow of fund accounts for equities, show a net annual reduction in the equity of brokers and dealers in Q3 2009 of $135.8 billion. However, the flow of funds numbers are adjusted on an annual basis.

This means that the actual net flows for broker-dealer equity were on the order of $34 billion — which is probably explained by mergers into commercial banking operations as a result of reorganizations resulting from the Crash of 2008.

Stock prices peak in 2010

One purpose of flow of funds analysis is to help interpret stock market peaks and valleys. In mid-January 2010, equity prices hit a ceiling and have been trending downwards for a month.

The fact that the Bear Market Recovery of 2009 was being driven by foreign investors and unsophisticated mutual fund shareholders, suggests that limits to further upward moves in equity prices, at least in the near future, may now be beginning to play a role.

In the article, “Barriers to a bear market recovery“, I mentioned three potential selling forces that equities would have to overcome in order to break through the high-water marks set in 2008:

1. The accumulation of un-exercised executive stock options;
2. The need of banks to raise funds to repay TARP money; and
3. The tendency of Baby Boomers to move out of equities, once the losses of 2008 are covered.

To these factors, we should add the probable effect on equity values of interest rates that should rise when inflation begins to kick in. The US consumer price index already had begun to move upwards in December 2009 and Ben Beranke made a first, timid increase in Fed-controlled intererst rates in February 2010.

And then of course, we have the old Wall Street saying, “As goes January, so goes the year”, which may have at least a psychological impact on some that follow the market.

Where do you think the Dow Jones Average will be in November 2010?