Clearing up some misconceptions about how the stock market works – FT Alphaville (registration)

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You can learn lots of interesting things by closely studying America’s Financial Accounts (formerly known as the Flow of Funds) published by the Federal Reserve, such as how the US stock market actually works.

First, the standard theory:

Just like everyone else, companies that want to spend more than they take in can raise money by selling financial assets to investors. Borrowing money from a bank or the bond market is common, but risky. If you miss an interest payment or violate any of the other covenants associated with your debt, you might end up being forced to shutter an otherwise worthwhile enterprise.

One alternative is to raise money by selling claims on future profits. If the business isn’t as successful as hoped, the company might have a tougher time raising additional funds, but it doesn’t have to liquidate. Shareholders have a chance for much higher returns than bondholders, but also much greater odds of losing all their money.

You’d therefore expect companies to fund their investment out of a mix of debt and equity depending on the underlying riskiness of their business and the relative yields of stocks and bonds. You’d probably also expect that companies in the aggregate raise more money by selling stocks to investors than they spend buying them back, while households buy more shares than they sell.

Yet data from the Financial Accounts make it quite clear that US nonfinancial corporations buy more stock than they sell, and have done so for decades. The figures track both the level of equity outstanding and the net flows (buying and selling) that affect this level, with the rest explained by changes in market value. Since 1960, cumulative net equity issuance has been negative $6.3 trillion (nominal):

The flip side of this is that American households and nonprofits, rather than net investors in the stock market, are actually net sellers:

Household equity holdings have grown over time because the prices of the shares they don’t sell have risen more than enough to compensate.

This is interesting, but an incomplete picture.

After all, stock prices go up and down (generally up) over time, while the dollar tends to lose value relative to goods and services. The charts below correct for this by dividing everything against the total amount of nonfinancial corporate equity outstanding at each point in time.

First, you can see that the apparent trend of businesses buying back as much equity as they can disappears when scaled against the total value of all shares in the stock market:

Here’s another way to show the same thing, this time dividing the quarterly net flow by the market value at the time:

The big change was in the 1980s. Falling real interest rates (from extraordinarily high levels) and exploding earnings multiples (from an extremely low base) encouraged companies to shift their financing mix from equity to debt. At the same, deregulation, particularly relating to the government’s approach to antitrust, encouraged a wave of mergers and acquisitions, often funded by debt. The invention of the leveraged buyout was another big contributor to de-equitisation.

Since the crisis, companies have been behaving more or less as they always have been, on average.

The behaviour of households and nonprofits also looks less outlandish when scaled against market values. With a few notable exceptions, they have tended to sell shares as prices rise, minimising the overall shrinkage in their position:

Here’s the flow perspective:

The Enhanced Financial Accounts provide even more details, by breaking down net equity issuance into new shares, buybacks, and M&A. There are also tables on the breakdown between initial public offerings and secondary equity offerings.

These data don’t go back as far as the un-enhanced Financial Accounts, but they do help clear up some misconceptions.

For one thing, the new supply of equity has been pretty stable over the past two decades. Contrary to fears about the death of public markets, companies are still happy to sell shares to raise money:

Of this new supply, the majority tends to come from secondary offerings rather than IPOs, but the mix tends to change in line with the business cycle:

The decline in the IPO share since 2014 looks odd, but can be partly explained by a boom in secondary issuance:

(Note that the total amounts raised by IPO and SEO are smaller than the Fed’s figures on gross issuance. We asked the Fed about this but haven’t gotten a response yet.)

This last chart puts everything together by scaling buybacks, mergers and acquisitions, new issuance, and the net creation of nonfinancial corporate equity against market value:

You can see that M&A is the most volatile component, while the pace of corporate stock buybacks tends to be pretty stable relative to the level of share prices. Contrary to popular belief, there hasn’t been a systematic increase in the rate of share buybacks. There was a temporary increase during the excesses of the 2005-07 period but that’s about it.

Hope this clears some things up.

Related links:
Equity Issuance and Retirement by Nonfinancial Corporations — FEDS note
Why should changes in population structure affect valuations? — FT Alphaville

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