Demand’s Unsung Partner

When will retail investors return to stocks? Is their faith in markets gone for good this time?

These and other similar questions have permeated headlines since the 2008-09 financial crisis. Speculation abounds about demand drivers, like where the cash will come from to drive stock prices higher. But you’ll find little to no reference to supply, or the quantity of securities trading on the proverbial playing field. Since both demand and supply drive prices, over-emphasizing one while ignoring the other paints only half the picture.

So what is current stock supply signaling? Despite a recent spate of IPOs, share count remains constrained. Wherever you think demand for shares—a fickle factor—is heading, supply growth does not appear to be outpacing it. In my view, this underappreciated positive should support rising prices looking ahead. As Economics 101 teaches us, if supply is shrinking or growing slower than demand then, all else equal, prices over time will rise.

To be clear: Demand is not solely determined by the amount of cash in potential investors’ hands. There is a portion of that cash that will never, no matter the fundamental environment, see equities. Demand is simply what an investor is willing to pay for a particular stock at a given price.

At its core the stock market is an auction. Investors taking stakes in the future earnings of a company compete to buy shares; if successful, they’ll likely have to outbid other investors. It takes only two competing buyers to bid up an item, with the final price determined by how much the highest bidder is willing to pay (assuming the owner is willing to sell). The price where the trade is consummated in turn impacts all of the company’s shares. Thus the amount of cash on the sidelines and the total number of buyers may not matter much.

Many variables impact share supply. Growth comes from IPOs, secondary offerings, issuances to fund mergers and acquisitions (M&A), option and warrant grants, debenture exchanges, preferred stock conversions and stock option awards for insiders. Supply can shrink too: Companies can buy back stock, get bought out in cash-based M&A deals, go private or fold. Companies can also re-list on foreign exchanges for tax or regulatory reasons, which impacts supply in the involved nations but which is basically zero sum globally. The regulatory environment, financial conditions and other similar factors also influence how much supply hits the market.

History shows supply creation tends to accelerate at or near market peaks as rising supply outstrips demand. You can see this phenomenon in both US stock-based M&A and IPO activity as measured in dollar volume.

Let’s delve into three of the key supply drivers and the signals they are currently sending:

- Share Buyback activity of S&P 500 corporations from 2005-2011 had a strong directional correlation to the performance of the S&P 500 Index. Quarterly volume rose for the bull’s first two years, hitting $127 billion in Q1 2011, but dropped off through Q2 2013 even as the bull market continued.ⁱ One explanation is firms focused on capex—growth-oriented spending—during this time rather than returning cash to shareholders. However, strong recent activity drove repurchase volumes to new cyclical highs by the end of Q3 2013. Looking ahead, given significant remaining capacity within previously announced buyback programs, rising profits, balance sheets flush with cash and high corporate bond issuance , there appears to be plenty of fuel for continued strong buyback activity and high capex investment.

- M&A Activity remains well below pre-recession levels. Contributing factors include tight credit supply (due largely to Fed bond buying, as described here), and macroeconomic concerns. Aggregate transaction volume and values over the past five years remain well below 2006 and 2007.ⁱⁱ Importantly, most transactions have been cash-based, shrinking share supply.

- IPO Activity on US exchanges plummeted after the dotcom bubble burst in 2000 and stayed muted through 2012. The 2002 Sarbanes-Oxley Act (SarbOx) likely bears some blame. By imposing a number of regulatory burdens (e.g., requiring top executives to certify the accuracy of financial information, hiking penalties for fraud, increasing board oversight responsibilities), SarbOx essentially discouraged companies from going public. The significant growth of the private equity market since the act passed likely isn’t coincidental.

The numbers vet this out. 1999 saw 485 IPOs with gross proceeds of $65 billion. In 2000, 382 IPOs fetched the same amount. However, in no year from 2001-12 did IPO volume exceed 183 offerings or $36 billion. From January 1, 2009 through the present (a rough approximation of this bull market to-date), 551 firms went public. This number is strongly impacted by 2013, during which 222 companies have raised north of $54 billion.ⁱⁱⁱ And even this upturn points to a release of pent-up demand, not euphoria, as 2013 was the first full year the Jumpstart Our Business Startups Act (JOBS Act) was in place. The law exempts firms with less than $1 billion in revenue from SarbOx’s more costly and burdensome reporting requirements. Law firm Latham & Watkins estimates nearly three quarters of IPOs since the JOBS Act passed were offerings from these emerging growth companies.

Due to these and other corporate actions, the current aggregate outstanding share count of the S&P 500 is similar to what it was in 2005. While some firms did relist internationally, there is no sign yet of a dramatic supply increase to indicate this bull has run its course. It’s also interesting to note that from 1997-2012 the number of US exchange-listed corporations dropped by 40%, from 8,823 to 4,916.^iv Perhaps not all of that is outright supply destruction, as some firms likely changed registration to foreign exchanges, but much of it likely is.

That said, while constrained supply typically supports stocks, something else can take precedence. For example, the 2008-09 bear market, spurred by mark-to-market accounting’s deleterious impact on bank balance sheets, occurred as the number of publicly traded US companies was declining.

Time heals all wounds and as this bull market continues, it’s likely the majority of retail buyers who fled equities will return. But even if that takes significant time—or some don’t return in this cycle—it’s an error to focus on demand to the exclusion of supply.