The Incredible Shrinking Market
Over the last 20 years there has been an interesting phenomenon in the US stock market. Simply stated, the number of listed stocks on US stock exchanges has decreased dramatically. See Exhibit 1 below:
Source: DFA Inc.
Note that the number of listed stocks peaked in 1997 and has continued to decrease almost every year since. Also notice that the number of foreign listed stocks has increased or remained stable during that time.
To view this in another way, see Exhibit 2 below:
Each year there are new stock listings and delistings. Note that in most years since 1996, there are a greater number of Delists than New Lists. This continuing trend is happening for three basic reasons:
- Public mergers and acquisitions
- Private mergers and acquisitions (private equity)
- Many new companies are staying longer in the private sector
Public mergers, such as Amazon buying Whole Foods or AT&T buying Time Warner, are recent examples of one public company buying another. Two publicly traded companies become one, even if the business names remain the same. While that doesn’t change the total revenues and earnings of listed companies, it does reduce the actual numbers of companies offering stock to the public.
Private acquisitions/mergers occur when Private Equity firms/funds buy a public company and take it “private”, or when a private company buys all the stock of a public one. Either method results in a company removing itself from public ownership.
Exhibit 3 below shows private equity deals that have taken place each year since 1996. There is little doubt that private equity is taking up the slack from the reduction of publicly traded companies.
Lastly, some companies decide to never become public, or wait for a much longer time to have their initial public offering, which in effect prevents investors from participating in their initial growth stages. For example, Amazon went public 3 years after their 1994 incorporation and raised over $600+ Million. Google went public 6 years after their 1998 incorporation and raised $28+ Billion. Facebook went public 8 years after their 2004 incorporation and raised $110+ Billion. Had the latter two companies gone public in their earlier years, investors could have shared in much more of the companies’ initial, and explosive, growth. But there was no hurry for Google and Facebook to go public, because they had no problem raising money privately.
Does this phenomenon change the way we should invest? Taken to an absurd conclusion, can we expect years from now that the last remaining 2 public companies, Google and Amazon, will finally merge together to become the only remaining publicly traded stock? Probably not. But there are valid questions that might be asked about whether the reduction of public companies has changed asset class investing.
For instance, what about certain market truths that are foundational in the way we build the portfolios that we manage? When 50% of stocks are removed from the market, as has been the case since 1997, are there any Small Cap stocks left that we would normally count on to outperform Large Caps over long periods of time? Chart 4 below answers that question.
Exhibit 4 shows that the distribution of market capitalization across size groupings was very similar when there were 7,301 stocks in 1997 and when there were 3,447 stocks in 2017. In other words, the reduction in publicly traded stocks has been happening across all size groups, rather than just in Small Caps, leading to little change in the overall size distribution of the stock market. There are certainly plenty of stocks in the market to maximize the statistical diversification needed in any asset class. This means that the factors that we use when building your portfolios - size, value/growth and profitability - remain the same even though the total number of publicly traded stocks within those asset classes has been reduced.
Someday the market for private equity companies may become so ubiquitous that it will have its own asset class, and/or a suitable way of including it into our client portfolios. Our Investment Policy Committee is currently looking into that exact issue. But, in the meantime, we believe that the shrinking number of publicly traded companies in the US stock market should not negatively impact the overall diversification of your portfolio.
Second Quarter 2018 Asset Class Returns
Domestic quarterly asset class returns were quite different from their foreign counterparts. All US equity asset classes had positive returns, with Small Caps leading the way for both quarterly and YTD performance. The volatile quarter ended on a strong note for domestic stocks, while all International classes came in with negative quarter and YTD numbers. One major reason for this was the strength of the US dollar. Weakened foreign currencies weighed down mostly all European, Asian and Australian stocks, and as a result International YTD equity asset class returns were all underwater, with Emerging Markets leading the way down. Bond yields continued to flatten, with intermediate and long term bonds’ modest capital erosion erasing any income return earned during the quarter.
The US stock market is continuing the multi-month consolidation which started in late January of this year. The proverbial “wall of worry” has plenty of bricks to go around. Trade wars are currently the most visible and popular reason for the volatility. The almost daily back and forth between the Trump administration and virtually all of America’s trading partners is stirring up fears that will most likely continue until either separate pacts between countries take place or the ramifications of tariffs are actually seen, measured and determined to be better or worse than originally feared. That may take many months to unfold, so patience is a necessity at this time. In addition, the Federal Reserve has continued its previously signaled rate increase in June, and announced its intention to have two additional increases as 2018 progresses.
The healthy US economy and higher interest rates have attracted foreign capital, thereby strengthening the US Dollar. This makes our goods and services a bit pricier on the global marketplace, and leads to a potential export slowdown in the future. Finally, the rate of inflation as of May ’18 came in at an expected 2.0% year over year as of May ’18* [by the Fed’s preferred PCE (Personal Consumption Expenditure Index)]. Some believe that rate will continue to increase and ultimately pose a further reason for concern. *Per fred.stlouisfed.org
The current consolidation of the stock market was late in coming, and healthy. After many quarters of positive returns and little pullback, the sideways action we are experiencing is allowing time for multiple earnings periods to report excellent results, which permits a somewhat overvalued market to gradually revert to more normal levels. We may have several more months of the same type of market swings we have become accustomed to during the first half of the year. Visibility to some of these issues may occur by the end of the year.
Please stay calm and levelheaded. Find yourself something or someone that is cool, and enjoy the remainder of your summer. The second half of the year is always the most interesting, regarding politics, favorite holidays and market performance.
Frederick F. Kramer IV, JD
Co-Chief Investment Officer