One of the most basic concepts in economics is that price is a function of supply and demand. Yet, oddly, equity investors tend not to think much about shifts in the quantity of the stuff they’re buying and selling. Factors that affect intrinsic value (earnings) are endlessly debated, as are the impact of central bank asset purchases on stock prices. But rare is the market report that begins: “The price of equities rose today because there weren’t as many good ones to buy.”
Joking aside, the shrinking supply of equities — a trend known as “de-equitization” — deserves attention, not least because it might help explain why stock prices keep touching record highs. Remarkably, the number of U.S. public companies has fallen by almost half over the past two decades, even though the U.S. economy and population grew. A decline can also be observed in the U.K. and Germany.
Takeovers, the rise of venture capital and the growing regulatory burden of going public have all contributed to that drop, according to Credit Suisse. In addition, today’s asset-light tech start-ups simply don’t require as much capital to fund expansion. It would be a stretch to argue this shift in itself has pushed up stock prices, especially lately. Most of the drop in listings in the U.S. happened during the dotcom era boom and bust.
However, the stock market has also become a more profitable place for those that have survived the cull. Thanks to rampant consolidation and laissez-faire anti-trust enforcement industries are becoming increasingly oligopolistic. Less competition makes it easier for public companies to fatten margins, and higher profits certainly do affect valuations.
But that’s not all. Since 2009, U.S. public companies have spent about $3 trillion buying back stock. That constrained the supply of stock, and the price went up in part because buybacks increase earnings per share.
Yet, rising equity valuations haven’t triggered a boom in initial public offerings. Companies that have gone public find it’s much cheaper to issue debt than equity. The upshot is that net equity issuance by non-financial companies has been negative by almost $6 trillion over the past two decades, according to data compiled by the Federal Reserve Board. (That’s equivalent to about a fifth of the current value of the U.S. market).
To be clear, I’m not saying investors are poised to run out of stocks to buy. Rising prices simply mean you get fewer shares for your money. Also, share buybacks aren’t nearly as popular in Europe, where banks have been issuing plenty of new stock to boost capital buffers. Plus, China and other emerging markets are still minting scores of public companies.
Even so, the U.S. accounts for a third of the world’s market capitalization and almost 60 percent of the MSCI World Index. U.S. investors typically have a very pronounced domestic bias in their portfolios. Increasingly, they are turning to passive strategies that allocate more money to index funds, regardless of whether all of the underlying companies are performing better.
“If you get fund flows coming into the U.S., you will see stocks getting bid higher because there are not enough shares,” says Steven DeSanctis, a strategist at Jefferies. Of course, corporate buybacks have begun to slow lately and, if that continues, it could become a headwind for stocks. But until that materializes, a lack of supply looks looks to be the market’s secret sauce.