The continuing stock rally in the face of a slowing economy and a cratering housing sector is something of a mystery, baffling economists and investors alike. But there could be a simple explanation: supply and demand.
Simply put, the supply of U.S. stocks available for individual investors, mutual funds, and index funds. Call it de-equitization. In the last few days, deals have been announced or concluded to take large publicly held companies private. HCA, the giant hospital chain, last Thursday announced the completion of its $21.2 billion leveraged buyout. The same day, Reader’s Digest said it would be acquired by private equity firm Ripplewood Holdings for $2.4 billion. This morning, Equity Office Properties, the huge real estate company, struck a deal to be acquired by the Blackstone Group for $19 billion. (Throw in the value of Equity Office’s debt, and it may be the biggest LBO ever.) At the same time, publicly held firms are buying back big chunks of their shares. Last Friday, Wendy’s said it would spend $800 million buying 19 percent of its outstanding shares.
This year is shaping up to be a record for both leveraged buyouts and stock buybacks. According to Thomson Financial, buyouts worth $334.5billion have been announced or completed so far this year, up from $115billion for all of last year. According to Standard & Poor’s, members of the S&P 500 Index spent $325.15 billion on their own shares in the first three quarters of 2006 and have spent more than $674 billion since Jan. 1, 2005. Between buybacks and buyouts, that’s more than $1.1 trillion of stock taken out of public hands in less than two years.
Of course, new shares are constantly being created, through secondary offerings of existing companies and initial public offerings. But these tend to come in much smaller batches, as this list of recent IPOs shows—a few hundred million here and there. According to Dealogic, IPO volume has totaled about $36 billion so far this year. IPOs are on track for an excellent year, but the money raised by this new supply of shares pales in comparison to the volume of buybacks and LBOs. And many of the world’s biggest IPOs now take place in Hong Kong and London—which means they’re off-limits to many American investors and mutual funds.
Given the size of the U.S. capital markets, it takes a big supply cut to move the market. But the scale of recent buybacks and LBOs may be enough. This morning, the market capitalization of the New York Stock Exchange Composite Index was $21.77 trillion, while that of the Nasdaq Composite Index was $4.22 trillion. Taking out one, or two, or three blue-chip companies doesn’t make that much of a dent in a $25 trillion marketplace. But it adds up. If leveraged buyouts and buybacks add up to $1 trillion for the year, which is entirely possible, that’s about 4 percent of the combined capitalization of all NYSE and Nasdaq stocks.
Clearly buybacks and buyouts make a difference to an individual stock. Investors value stocks in part based on earnings per share. And when the same profits are distributed over a smaller number of shares, earnings per share rise, making the stocks look more attractive.
Psychology also plays an important role in stock valuation. And, here again, the de-equitization trend may be spurring higher valuations. Companies, which have enjoyed a record run of profits, still have lots of cash sitting on their balance sheets—and investors believe they could use that cash to buy back more stock. Members of the S&P 500 collectively had $611 billion in cash as of Sept. 30. Meanwhile, data from the National Venture Capital Association show that so far this year, buyout funds have raised $84 billion, compared with $96 billion for all of 2005, and $25 billion in 2002. So, investors now buy stocks with a reasonable expectation that (a) the company might buy more shares back from them, or (b) a private equity firm might offer a premium to take the company private. Both results, which reduce the supply of shares, create higher stock prices. In other words, investors may be buying stocks—and driving up prices—in anticipation of buybacks or LBOs that would push up prices even more. The presence of deep-pocketed corporate and private equity buyers standing at the ready creates what Citigroup strategist Tobias Levkovich calls “an underlying bid,” which tends to dampen volatility and stop prices from falling too far. And it tends to scare away short-sellers.
Extrapolating from existing trends is always a dangerous trap for investors. But if current trends continue, stocks may join oil, textile plants, and moderate Republicans as formerly abundant national resources that are in increasingly short supply.