The incredible shrinking stock market will continue to contract

The number of shares in issue and available for investors to buy has been falling for years. There’s little sign of this trend reversing just yet.

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  1. Garry White

Stock markets are shrinking fast. This could be interpreted as good news for shareholders, as the law of supply and demand dictates that reducing the amount of shares available should increase their price. Indeed, this so-called “de-equitisation” trend has been a positive factor in the post financial crisis bull run. But this isn’t really such a good thing over the longer term, as investment opportunities in public markets evaporate. So what can be done to reverse this trend?

De-equitisation – the shrinking of the amount of equities in issue through share buybacks and M&A – has arguably been helpful to valuations for a number of years. Citigroup has looked at its impact this year and advised anyone that wants to play the de-equitisation theme – ie invest in markets that are shrinking in order to take advantage of the positive impact of falling supply – to look at the UK and US. The total number of shares listed in London has shrunk by 3% since the start of 2018, with US markets now having 2.3% fewer individual shares available than at the beginning of January this year. Citi has calculated that most of the shrinkage in the UK is down to M&A – as companies such as Shire, Barrick Gold, Dairy Crest and Jardine Lloyd Thompson have delisted. In the US, the major driver has been share buybacks – as the impact of the Trump tax cuts continues.

The main driver of de-equitisation is the fact that debt is cheap and equity is expensive. “This is a rational response to a radical shift in the cost of equity and debt financing,” Citigroup said. “[Developed] stock markets are shrinking as companies reduce dilutive cash piles and substitute expensive equity with cheap debt, which is usually earnings per share (EPS) enhancing”.

US businesses in particular have been buying back shares at an accelerating pace. In the five years up until the start of 2018, S&P 500 companies repurchased about $2.9 trillion in equity. However, in 2018 overall US buybacks topped $1 trillion in a single year for the first time ever. This has been happening at a time when US markets were hitting or sitting close to all-time highs, so arguably companies are paying too much for their own shares. However, management feel able to spend so much buying their own shares because of the high cost of equity relative to debt and the positive impact on EPS that buybacks have. It is seen as a shareholder-friendly action.

Another negative is the fact that the relative attractiveness of share buybacks under these conditions could lead to a reduction in business investment. Indeed, the acceleration in share buybacks resulted in US senators Bernie Sanders and Chuck Schumer unveiling proposals earlier this year to limit buybacks, as they argued the process only benefits the rich by supporting equity markets, while reducing investment for growth and keeping wages low. It is true this capital could be better deployed.   

Although this trend is providing some support in markets right now, it will be damaging over the long term as investors chase too few opportunities. But this trend does not look like it will go away any time soon, as the cost of debt looks likely to remain lower than the cost of equity for quite some time. Indeed, interest rate futures are now pricing in an interest rate cut by the Federal Reserve in both September and January, which means the cost of dollar debt is likely to fall once more and reinforce this trend. However, Donald Trump’s tax cuts are unlikely to be repeated so the rate of share buyback should start to slow.

Coupled with the lacklustre IPO market – as the total amount of companies listed in markets has also been falling – this creates a quandary for investors. If a dearth of equity is inflating equity values higher than their rational level, this creates a potential risk. This is why there is an increasing trend in collective investment for funds that have investments in unquoted businesses – a trend that only looks set to accelerate as the universe of stocks shrinks.

Over the longer term authorities will need to encourage more companies to come to market. This is likely to involve easing the amount of red tape – and even the frequency of earnings reporting – to make public markets more attractive. However, a reversal of this trend isn’t likely until the cost of debt rises to a more historically normal level. That is unlikely to happen for quite some time.

A version of the story appeared in Friday’s Daily Telegraph.

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