Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.
Some wonder these days why the US public equity market continues to stretch to almost daily new highs (at least of the Dow) while there is apparently much evidence of a real slowdown in economic growth. One answer is from the chartists, including my colleague Dr. Hank Pruden who heads Golden Gate University’s Technical Market Analysis Program, who probably was the first (circa 2003) to predict the current Dow run-up to 14,000 (now adopted by Jim Cramer and many Street analysts for a late 2007 arrival).
Another reason, noted in my prior posting regarding the Federal Reserve’s inscrutability (I’m not sure whether we want the Fed to be “scrutable”), could be that some of the data about economic torpor may just be wrong — specifically, the early estimate of Q1 GDP. We’ll know more with the next estimate at the end of May, but it does seem apparent from more direct data that the consumer did slow down spending in April (if only to stay out of the cold; which should not have affected Internet shopping, however).
A third and more simple reason may just be the basic dynamics of supply and demand. Just as in the boom years of the late 90′s, when as much public equity was retired by buy-outs and repurchases as was added by IPO’s, the simple shortage of aggregate equity may be having an upward impact on overall prices. The 90′s decade also witnessed a rush of new money into equity funds because of conversion of “defined benefit” into “defined contribution” pension plans across a wide swath of corporate America, and contributed to the imbalance of supply and demand in the boom period. This phenomenon has not continued at the same pace since 2000. On the other hand, the current period reveals an actual DECREASE in aggregate public equity year-over-year (about 5% in the latest measures) as a number of factors have contributed to a literal “privatization” of the market for equity shares.
Share repurchases, funded by still cheap debt in relative historical terms, are proceeding at high levels; so are leveraged and other private equity buyouts. And M&A transactions, though down in number lately, are nonethless up in volume, and deals done for cash take more equity “off the market”.
At the same time, Sarbanes Oxley seems to have made IPO’s “safe, legal and rare”. Thus we have another example of the “unintended consequences” of reform legislation: just as the 1993 tax deduction cap on cash compensation to top executives began the explosion in stock option compensation in the 90′s, we are witnessing a not-so-gradual reduction in aggregate public disclosure about equity issuers’ business and financial condition because more and more companies are choosing to “go private” or stay that way, if only because they cannot afford Sarbanes-Oxley audit costs.
Also, many small but growing companies may not wish to go public without the prospect of a reasonable amount of research coverage, which post-Sarbanes has become uneconomic for investment banks except in respect to the largest equity names with broad institutional ownership already in place, because the banks can no longer fund research costs from banking fees either directly or indirectly.
Finally, as the US equity market becomes more private, it it also seems to be becoming even more an ‘insider’s game”. A new form of “whisper market” is emerging with the growth of equity options exchanges, where the rumor of a merger or buyout bid can now be monetized very cheaply with call purchases which in turn can be counted on to drive up the price of the underlying equity if only for a short time until the rumor is either confirmed or discounted.
Indeed, market professionals (as well as the SEC) are noting with interest the rather substantial number of such rumors and related trading patterns that have proven to be presciently accurate — think of the action around the Dow Jones bid as only the most recent example. As I write on this Friday, rumors abound about at least a half-dozen public equity stocks, looking perhaps to “merger Monday” announcements. Will this new form of the old “pump and dump” boiler room game, albeit with its positive effect on the market’s march to 14,000, prove to be the “options backdating” scandal of 2007?
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Research in behavioral finance has clearly identified a “bandwagon effect” in investor behavior: as the market continues to rise, with or without the support of economic fundamentals, more and more investors are convinced of the need to get on the train before it leaves the station. Some of this bandwagon effect may manifesting itself in current market performance.
There’s an irrational element in this desire, and the dot-com crash made clear the potential for disaster that accompanies any headlong rush into the market. But the historical record also suggests a certain method to this madness. That is, over the long term, the cost to one’s portfolio return from being out of the market as it rises is greater than the cost of being in the market when it falls; sins of omission, in other words, are penalized more heavily than sins of commission. And to the extent that such asymmetry continues to characterize the equity market, investors jumping on this bandwagon may be doing just the right thing.