The Incredible Shrinking Stock Market

Supply and demand.  As we have noted, when supply decreases, demand increases.  Increasing demand means, in most cases, higher prices.  And vice versa.  Build too many houses and you have a housing 'crash.'  Take stocks off the table and the prices of the remaining stocks goes up.  Do the reverse and stocks go down.

And they did the other day.  An interesting thing about finance theory is that it is one 'science' where theory pretty much matches reality.  Not all the time but enough.  One of the biggest shocks I had coming out of business school was that business actually used some of the tools taught in school.

So here is the real life example of stocks doing what theory says they should do.  On Monday, I think, airline stocks as a group went down about 1% plus.  American, Northwest, Southwest, anybody that is left, went down.  Why?  Because Delta is almost out of bankruptcy which means there will be more shares of airline stocks in the market.  More shares means existing shares get 'diluted', another finance term taught in business school. 

But in general the reverse is going on.  Shares are disappearing from the market.  Disappearing shares bode well for the shares that still appear and the price should, and has, been going up.  Why are they disappearing?  The answers are--

1) Share Repurchases.  Companies realize that they can borrow after tax money for 3% plus and buy their undervalued shares thus making their remaining shares go up in value.  It also means that management may save their jobs by getting the stock price up.  Never underestimate a management group that is threatened with losing their jobs.  As Samuel Johnson wrote, Nothing concentrates like a hanging.

How much share repurchasing is going on?  Well, just happen to have the number here somewhere.  Let's see.  In 2003 share repurchases totaled $180 billion.  In 2006, share repurchases totaled $670 billion.  Of course, shares were cheaper in 2003 but that is still a lot of shares being taken off the table.

2)  Global mergers are back.  In 2000, there were $790 billion in global mergers.  In 2006, there were $850 billion.  No big deal.  But mergers in 2000 were huge and stupid--this was the dot.com time frame.  So compare today not to 2000 but to 2003 when mergers totaled only $200 billion.  And now mergers are real--companies buying real assets and not sock puppets--and the shares are disappearing making remaining shares more valuable.

3) These are cash mergers, not stock mergers.  In the old days, the mergers were stock deals.  Let's swap my shares for your shares creating just a bunch more shares.  Now deals are for cash.  Why?  Cash is cheap.  Borrow at 3% plus to buy a company with a PE of 15.  A PE of 15 results in an earnings yield of 6.7% (1 divided by PE of 15 results in an earnings yield of 6.7%).  Contrary to what most people think, corporate executives can add, subtract, multiply and divide and it doesn't take a Phi Beta Kappa to figure out that a cost of 3% that results in a return of 6.7% is a good deal.

So that is why stocks are disappearing and making the remaining stocks more valuable. 

Tomorrow--why politics are good for stocks.  And then some clouds on the horizon.