Stocks, Bonds, LBO's and PPT's

Why was the stock market -until recently- so apathetic to the various negative signals coming out of the economy and credit markets? Many point fingers to the so-called Plunge Protection Team (PPT), which has supposedly moved from rare interventions during crisis events to full-blown daily manipulation.

It is a matter of definition as to what or who exactly is the PPT but, as I have said before, the market is now easier than ever to "steer", strictly from a means and methods standpoint. These are the reasons:

1. Individual investors and speculators have mostly departed the scene, leaving the game to the professionals (pls. refer to post from May 18, 2007). This is important because it is impossible to consistently predict and control the actions of millions of individuals holding thousands of different shares. The best example is what happened during the 2000-01 day-trader craze.
2. The market has become derivativized to an unprecedented extent. On any given day the top most active issues are the various trackers (QQQ, Russell, super-shorts, etc.). This is a market where the derivative tail wags the cash-market dog, at least for the index-heavy issues.
3. The emergence of highly capitalized hedge, private and sovereign funds has concentrated the market into the hands of fewer players, in combination with the few global prime brokers, who also actively trade for their own account.
   

It follows that the market's facade (i.e. the popular indices) has become theoretically easier to manipulate on a daily basis. Nevertheless, effective manipulation requires more than the ability and the means to do so; there must also exist an underlying current, a fundamental backstop upon which daily operations can be based. In other words, there must be ultimate buyers or sellers of cash stocks, depending on what kind of manipulation is being undertaken (bullish or bearish).

Since we are currently talking - theoretically, always - about bullish manipulation by the "PPT", we must look for ultimate buyers.

In this regard, one of the most revealing charts I have seen in months is the net amount of equity withdrawn from US markets through buy-backs, buy-outs and LBO's (black bars, chart below - click to enlarge). The amount reached a record $210 billion in the 3Q2007, from near zero in early 2004.

Chart: FRB

The US has never before experienced such a sustained equity withdrawal in the history of its public markets. In just four years between 2004-07 total net equity withdrawn came to over $1.6 trillion, an enormous sum when compared to US market capitalization (end-2003: $14.3 trillion, end-2007: $19.9 trillion). The effect was to provide a constantly growing underlying "bid" for cash shares, one that leveraged the performance of indices: while total capitalization rose only 39% in the above period, the S&P 500 index gained 67%, i.e. 70% faster. (Does this make it a Potemkin village market?)

Where did the money for the buy-backs and LBO's come from? Some came from corporate earnings, which reached a record ratio of GDP; but most of it came from debt. Record low credit spreads and volatilities encouraged CFOs and private equity funds to buy shares with borrowed money. Investment bankers, always fee-hungry, piped in with their advice: "There is too little debt and too much equity on corporate balance sheets". (The same bankers are today eating their words as they go hat-in-hand to raise emergency capital for themselves, but that's a story for another day.)

The chart below shows net issuance of bonds (i.e. new debt) by US corporations. The total amount during 2004-07 came to $3.2 trillion, another record. Given the furious M&A and LBO activity in 2005-07, obviously a big chunk of that money went to finance share purchases.

Chart: FRB

To sum it up: the market was riding a sea of buy-backs, M&A's and LBO's that were financed by cheap and easy credit. The "PPT" helped things along, taking advantage of the means, methods and conditions mentioned above, to support their own books. By my definition, therefore, the "real" PPT is a loose association of major market players that trade their own book taking advantage of dominant position and back-stopped with customer orders from LBO's, etc. It's the oldest game in Appletown: taking advantage of customer flows, with some new bells and whistles added.

As to the future: the credit crunch slashes LBO and M&A activity, while lower corporate profits reduce share buy-backs. The sovereign wealth funds will be more prominent, but they don't have the same equity and risk appetite as the other players. In addition, they are subject to significant internal political and power-play pressures. If their investments show mark-to-market losses, their managers will quickly go into CYA (cover your ass) mode. Add all these together and the conclusion is that customer flow is ebbing quickly.

The consequences for ongoing "PPT" operations are, in my view, quite obvious.