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What Does Shrinking Equity Supply Mean?

My friend Brian Reynolds, chief market strategist at MS Howells & Co., has long said that Buybacks have been a driver of stock prices, with the shrinking float the key reason why. Econ 101 says that reduced supply with the same demand equals increased prices.

There are some caveats: Companies always could add shares back by new issuances, so equity is not quite like a commodity with a finite supply (Oil and Gold come to mind).       

We were discussing this in the office yesterday, and the example I used was Paul Kasriel's recent chart. It showed up in Barron's today, with an interesting spin, and that's kismet enough for me:

"THAT DANDY LITTLE CHART WITH THE HOPEFULLY catchy head of "Off a Cliff" on this page comes to you courtesy of Paul Kasriel, Northern Trust's crack economy watcher. What it shows is the dramatic shrinkage in the supply of equities; all told, a record $548 billion worth was "retired" in '06. As Paul explains, rather than using their vast profits to fund capital spending, corporations have been buying in their own stock, hand over fist. Further soaking up the supply of stocks has been the explosion in private equity. It's hardly a surprise, then, he says, that stock prices moved up as smartly as they did.

Paul also points out that the massive corporate buybacks and scarfing up of shares by the acquisition-hungry private- equity types have had another effect: Together with mortgage-equity withdrawal, they've helped fund the $503 billion deficit that households ran last year. Said households, either directly or indirectly via mutual funds or pension funds, he reckons, were net sellers of stocks in 2006.

Which suggests, according to Paul, that unless corporate buybacks or personal income steps up sharply, with mortgage-equity withdrawal (MEW) likely to slow further this year, Jane and John Q. will have to clamp down on their spending. The stage seems set, in other words, for the end of the great consumer buying binge."

A few things worth pointing out:

• If MEW slows, that would potentially engender either more stock selling to fund a certain lifestyle -- or decreased consumer spending.

• There is, according to Barron's, a "sizable build-up in pending new issues. By one savvy estimate, the number of IPOs in '07 could shoot up a formidable 50%."

• Share repurchases are heavily dependent on corporate profits. If the earnings deceleration trend continues, so too might buybacks.

One last thought: Late 1990s saw a similarly large net share decrease. As prices rallied to new highs, we saw a return to trend. Once the market cracked, buybacks went away.

In other words, the psychology of the financially engineered buyback is a double-edged sword. If either the market seriously corrects or the economy slows (or both), we should expect buybacks to drop too.

>

Sources:
Dipsomania?
ALAN ABELSON
Barron's, March 12, 2007      
http://online.barrons.com/article/SB117337756928631125.html

Corporate Equities: If the Supply goes down, the Price is Likely To Go Up (PDF)
Paul Kasriel
Northern Trust Global Economic Research, March 8, 2007
http://web-xp2a-pws.ntrs.com/content//media/attachment/
data/econ_research/0703/document/dd030807.pdf

Saturday, March 10, 2007 | 08:03 AM | Permalink | Comments (45) | TrackBack (1)
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Comments

"Kismet" ? Hadn't heard that word used in a long time.

Googled the word, interesting what turned up.

To me, it pretty much looks like stock buybacks have replaced dividends and/or capital funding.

Long Term that has to be a disaster for workers(maybe even business in general) if paper gains become the only future economic growth for the US.

and then you have to wonder what happens when that well runs dry too?

Have a good weekend

Posted by: MarkTX | Mar 10, 2007 10:11:28 AM