Unexpectedly Intriguing!
February 12, 2007

Here's a neat bit of data that suggests one contributing factor to the stock market's strong performance last year. Did you know the supply of stocks in the U.S. stock market is shrinking? We came across the following chart from Schwab's chief investment strategist Liz Ann Sonders a while ago, which shows the annual change in net new equitives from November 1995 through November 2006:

Of course, the stock market has changed tremendously in size over this time period, so we did a little bit of digging and found where Liz Ann has shown the size of these changes as a percentage of the entire market:

This particular chart is nice in that is shows the relative changes over a longer period of time, going all the way back to 1976 (but ending in September 2006). We can also see that the current decline in the supply of equities is on par with the leveraged buyout boom of the mid-1980s.

How is the U.S. stock market shrinking? For the most part, a huge increase in the amount and number of private-equity buyouts (the chart below shows the 1995 through 2006 timeframe again):

Of course, the real question is why is the U.S. stock market shrinking? Our list of items on our running hypothesis list include:

  1. The U.S. stock market has become unattractive for new IPOs. Better deals are being found in other countries' exchanges.
  2. Increased regulation of publicly-traded companies (via Sarbanes-Oxley) has made it more attractive to take companies private. We'll note that the high cost of regulatory compliance would also make the U.S. stock market unattractive for new issues.
  3. Massive stock buyback plans, particularly in the energy sector. This really would have no effect on the attractiveness of the U.S. stock market.

As we noted above, one of the main beneficiaries of this trend is existing U.S. stockholders, who benefit from having approximately the same supply of money chasing after a declining number of stocks.

The main downside to the same investors? As stocks become more expensive per share, it becomes more difficult to purchase a fixed quantity of new shares. Also, there may be somewhat of a distortionary effect on reported company financials, such as earnings per share, that lead people to do some very stupid things.

Here's a quick example of what we mean. Let's assume that a company's earnings (profits) are unchanged when reported year over year. Here, the company's decreased number of shares will tend to make its stock look as if the company's actual earnings have increased (as measured by earnings per share), which might fool some relatively clueless observers (namely, unsophisticated investors, reporters and politicians) into believing that the company is still growing its profits.

While an unsophisticated investor might only lose some money on their investment, the combination of reporters and politicians is more dangerous in that the unscrupulous among these groups might point to a company's or sector's "record" earnings per share and begin calling for a windfall profits tax to be imposed upon them, ignoring whether or not these are "real" profits.

This scenario represents the real losing situation for the U.S., as these kinds of taxes make the U.S. economy less attractive in which to do business!

But hey, that's just us pointing out the obvious!

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