Honey I Shrunk the Stock Market- Why This is Good News for Your Portfolio

The stock market is shrinking and that is good news for investors. A long wave of acquisitions and stock buybacks is cutting the supply of public stocks.

Most investors see the headlines of a mega-merger like the proposed Aetna (NYSE: AET) -CVS (NYSE: CVS) hookup and recognize how bullish this is for these particular stocks. But it’s also good for the health of the overall stock market.

The principles of these market economics are quite simple.

  1. New issues, known as IPOs, and secondary stock offerings increase the supply of stocks.
  2. Cash acquisitions reduce the supply of stocks.
  3. Stock buybacks reduce the supply of stocks.

Each one of these metrics is moving in the same direction. The result is a shrinking supply of available stocks.

The good news for investors is that acquisitions and buybacks are happening at increasingly higher valuations. This puts more money in investors’ pockets.

This bundle of cash now needs to find a home, that is, a new investment. The increasing pile of cash being sent back to investors must be invested in a market where supply is shrinking.

The result: Higher stock prices.

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Buybacks Escalating

Every time a company buys back shares, the shareholders receive cash. This transaction increases the supply of dollars looking for new investments and reduces the number of available investments.

In the past five years, companies have repurchased more than $2.2 billion of stock. Interestingly the high valuations of stocks have done little to dampen corporations’ enthusiasm for buybacks. Just in the past month Bank of America (NYSE: BAC), Home Depot (NYSE: HD), Johnson Controls (NYSE: JCI) and T-Mobile (NSDQ: TMUS) have all signed off on new buybacks.

Deals, Deals and More Deals

Mergers, especially those where cash is traded for shares, present the same problem. When Amazon (NSDQ: AMZN) bought Whole Foods for $21.5 billion last summer, each Whole Foods shareholder received $42 in cash.

Roughly $1.6 trillion of acquisitions closed on U.S. companies in the past year. This doesn’t include the giant $69 billion proposed purchase of Aetna by CVS. Each day when my computer fires up, new merger speculation fills the newsfeed:

“Broadcom Pitches $103 billion Acquisition of Qualcomm”

“United Technologies to Acquire Rockwell Collins for $30 billion”

And earlier this week:

“Now Starring in Hollywood: Consolidation”, a nod to Disney’s rumored talks with 21st Century Fox.

Each one of these deals, if closed, will reduce the number of publicly traded shares. At the same time, they will increase the cash sitting in investment accounts.

The Disappearing IPO Supply

Usually, the supply of shares offered via the IPO and secondary issue markets counterbalances the shares removed from the market.

But this year is different. The IPO market is a disaster this year. Not only are the number of new issues shrinking, but most importantly, the value of these news deals is shrinking. The largest deal this year was Snap’s (NSDQ: SNAP) IPO which offered 200 million shares at $17.

Most IPOs this year were very small with valuations of only a few hundred million.

When Demand Outweighs Supply Prices Rise

According to data from the Federal Reserve and Standard & Poor’s, the amount of money pulled out of the stock market has been greater than the value of new stock issued since 2010. This supply and demand imbalance compounds each year and pushes prices higher.

Until the supply grows enough to sop up most of that demand, stock prices will likely move higher.

What To Read Next?

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