In the worlds of business and finance, two axioms universally apply: Timing is everything, and information is everything.
These two statements even determine whether insider selling and pump and dump schemes are legal.
In hindsight, it is quite blatantly obvious when it is illegal. Enron used bad accounting and revenue calculations to artificially pump up share prices, all while the C-suite executives cashed out.
29 Enron executives sold overvalued stock for more than a billion dollars before the company went bankrupt.
The same goes for Jordan Belfort, of recent Wolf of Wall Street fame. He and his boiler room team sold shares on lies and misinformation, collecting massive fees.
Both examples crossed the line when the investors were lied to or information was withheld.
The inverse of that distinction is what makes legal insider selling and the current market-wide pump and dump system perfectly legal.
If the information is available, it is perfectly fine. However, that doesn’t mean investors are smart enough to pick up on it.
That creates a strong personal profit opportunity for insiders.
Pump up Prices
The first step, naturally, is to get share prices higher. In the aftermath of the recession, that meant digging out of a massive hole in a horrible business climate.
Consumer spending was abysmal, credit was nonexistent for small businesses, wages dropped, and many were without work at all — often because the same businesses looking for a boost fired them.
In the new normal, a rally couldn’t happen through the tried-and-true strategy of increasing capital expenditures to create growth of sales and revenue.
Luckily for corporate executives, sitting idle and at a loss for how to adapt to the new normal, the Fed stepped in and appointed itself as the grand protector of markets.
Of course, the Fed could really only tinker with the “trickle down” tools of monetary expansion and low Federal funds rates.
This gave corporate executives an easy way out. Existing debt was turned over into cheaper loans, and additional debt fueled share buybacks without affecting cash flow.
$18.2 trillion of bonds have been issued worldwide since 2008. Currently outstanding corporate debt has risen over 50% to nearly $10 trillion over the same period.
Check out this chart from Andrew Smithers:
The buyback frenzy has only increased since this chart was created.
As The Economist noted a week-and-a-half ago, “The companies in the S&P 500 index bought $500 billion of their own shares in 2013, close to the high reached in the bubble year of 2007, and eating up 33 cents of every dollar of cash flow.”
And as Dan Strumpf of the Wall Street Journal noted on September 15, 2014:
“Corporations bought back $338.3 billion of stock in the first half of the year, the most for any six-month period since 2007, according to research firm Birinyi Associates. Through August, 740 firms have authorized repurchase programs, the most since 2008.”
Couple these quotes with what Mr. Smithers stated in the article containing the chart in the Financial Times:
US top managements are receiving huge bonuses which are typically linked to earnings per share or the return on corporate equity. This means that buybacks increase their pay and investing in equipment pushes it down. The result is that companies spend less of their cash flow than ever before on capital investment and have increased their buybacks to near record levels (chart three).
Corporate executives made their companies look stronger on paper, fulfilled their duty to boost shareholder value, and conveniently recouped — then exceeded — the wealth lost in large equity positions in the companies they control.
All of this information is being divulged, but is easily missed by a vast majority of investors, or not divulged by the buy-side brokers collecting fees from transactions.
As long as the information is available, caveat emptor. Bring on the greater fools.
Dumping Shares
Gains aren’t realized until stocks are sold, and corporate executives are well aware that the short-term EPS boosts will not boost profits.
Buybacks enabled by debt may ultimately hurt profits as interest rates rise as well.
So what to do when share prices and the market are at all-time highs while future prospects are questionable and growth is anemic?
Start selling and stop buying, of course.
According to data compiled by Bloomberg and Washington Service, a total of 7,181 insiders bought their own stock this year and 23,323 sold shares.
“There is a disconnect between what the market is doing and the economy is doing,” Terry Morris, a senior equity manager who helps oversee about $2.8 billion at Wyomissing, Pennsylvania-based National Penn Investors Trust Co., said by phone on Sept. 15.
“If management doesn’t feel confident enough about the future, they’re going to be net sellers,” emphasized Morris.
Boy, are they selling. Over the last four weeks, insiders have sold just under $5.5 billion of their company shares, as compared to $117 million shares bought.
That puts the ratio at a whopping 47 to 1. Corporate insiders haven’t been this bearish in any given year since 1990.
When insiders are selling, it sends the message that they believe their company’s shares have become fully valued and, therefore, have limited upside.
Who else knows better how well a company will fare weeks, months, or years down the road. As long as the companies divulge enough information to keep in compliance with the painfully toothless and inept SEC, this is perfectly kosher.
Unfortunately for small investors who cannot spend time digging through quarterly reports, the odds are stacked against them.
Corporations bury the details on debt, earnings, profits, and buybacks deep in their reports, and often use absurdly creative accounting practices that are simply referred to as “adjusted” or “non-GAAP” to hide the implications.
In the end, the market always needs a greater fool, especially when market gains are unsustainable.
All these self-serving actors — insiders, brokers, and buy-side analysts — only need to make the fact that the rally is built on smoke and mirrors available.
They don’t need to explain how it works, and it is up to you to find it once the disclosed information is slipped into the fine print or quietly published through the corporate web site.
And that is all that really separates an illegal pump and dump scheme from business as usual in the new normal.
Caveat emptor. Stay disciplined and careful.
