The Speculator
Why stocks should
rise 19% this year
Execs are smart enough to offer stock when their
companies are riding high -- and often, it's a sign they're about to fall. But
last year's dearth of offerings suggests stocks are about to start climbing
back up.
By Victor
Niederhoffer and Laurel Kenner
The
time has come for all good investors to turn their attention from the fortunes
of war to the fortunes of stocks. To encourage this historic shift, we wish to
share something of great value -- one of the best stock market indicators we’ve
ever encountered.
Developed
by a pair of 20-something Harvard grad students, the indicator is based on the
amount of equity raised by corporations. The lower the percentage of equity
issued vs. total capital (equity plus debt) raised in a given year, the better
the stock market returns the next year.
Right
now, that percentage is an exceedingly low 6% for all U.S. stocks -- the lowest
level since the 1930s. Proportions this low generally precede substantial rises
in the market.
To
put things in perspective, the amount of money raised in the equity market each
year is highly variable. Equity issuance tripled from 1927 to 1929, right
before consecutive annual market declines of 47% and 15%. In 1929, the $6.7
billion of equity raised was some 2.5 times higher than the $2.6 billion of
debt raised. Equity issuance fell drastically to $24 million in 1932, vs. $620
million of debt -- and the market doubled over the next four years.
In
our day, a comparably dramatic rise and fall occurred as equity issuance rose
from $96 billion in 1998 to an all-time high of $185 billion in 2000. The first
three years of the 21st century brought stock market declines of 10%, 13% and
23%. The good news is that the amount of equity raised has dropped some 50%
from the 1999 and 2000 levels to just $75 billion a year in 2001 and 2002. The
percentage of equity raised last year compared with total equity plus debt
issued was a mere 6%. This is the lowest level since 1932, when the market went
up an average of 28% a year for the next four years. (Our source is the Federal
Reserve Bulletin through 1997, and Spec Duo updates through 2002.)
What a deal -- for the sellers
To
gain perspective with some real-life examples, consider the companies that
raised at least $250 million on the secondary-offering market in 1999. That
year, the total amount of stock sold by corporations rose from $96 billion in
the previous year to $173 billion -- a full 23% higher than the previous record
of $136 billion in 1997. The prescient timing of these corporations is
highlighted in the table below. (We list offerings by U.S. companies of least
10 million shares, priced at $25 a share or more at the time of the offering.)
Admirable foresight
|
1999 secondary offerings and subsequent performance |
||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
Of
the 13 companies that crossed the $250 million barrier, not one was up as of
April 7, 2003. The average decline to date was 68%. The standout, of course, is
the now-bankrupt Enron
Although
we only list U.S.-based companies, the 13 million-share offering of United
Pan-Europe Communications
In
going over this list, the call of the auctioneer of Oriental rugs springs to
mind: “This beautiful, 19th century rug is an exemplar Tabriz carpet with
Ardebil design. The bold, striking pattern is etched in vibrant colors that
have scarcely faded on the rich, plush brocade pile. The brilliant silk border
will also appeal to the collector's eye. Originally cost $35,000, now yours for
just $995!”
We
will not report the same list for 2000 or 2001, although the qualitative
results would be similar. Yet we cannot pass over this subject without noting
the presence in the 2001 “seasoned equity” issuance list of Tyco
International
From the shareholders' pockets
There
is a meal for a lifetime for investors in these numbers, just as there was a
meal for a day for the corporations. Somehow, these companies timed their sales
both at favorable times in both the market cycle and their own lifecycle. This
is quite consistent with the findings of academic research on this subject.
The
seminal study is “Equity Issues and Offering Dilution,” published in 1986 in
the Journal of Financial Economics by Paul Asquith and David W. Mullins Jr.
They found substantial underperformance of companies that issue stock in the
second year after the secondary issue. Furthermore, the announcement of an
offering tends to create an immediate decline of 3% over the next two days. The
loss in market value to the company comes to some 30% of the funds raised.
Amazingly, one-quarter of the companies show a loss in market value of more
than 50% of the money raised. Thus, a substantial part of the money raised
comes out of the pockets of existing shareholders.
Academic
and case studies are both consistent with the view that executives in companies
issuing stock are quite prescient in forecasting not only the performance of
the stock market but their own particular positions in the firmament. Evidence
like the above led two Harvard grad students to start work on what we consider
one of the finest and most useful papers on predicting the market ever to
appear in an academic publication.
The
students were Malcolm Baker and Jeffrey Wurgler, now assistant finance
professors at Harvard and New York University, respectively. Their paper is
called “The Equity Shares in New Issues and Aggregate Stock Returns,” and it
was published in the Journal of Finance in 2000.
The
tendency of companies to issue stock before dismal times in the market and the
company’s lifecycle is only one blade of the scissors. The other blade is that
companies do not issue stock in dismal times, but instead resort to debt to
finance investments. This is a positive vote for the performance of their
company. Furthermore, they forgo issuing stock before occasions when prospects
for their company and the market look especially good. Aggregating these
individual tendencies, the professors hypothesized that the higher the
proportion of equity issued in a given year relative to total debt plus equity
issued, the lower the expected return for the market in the next year.
The
professors’ hypothesis was borne out in spades. Looking at the quarter of all
years when the proportion of equity issued was lowest, the actual return for
these companies during the next year was 11%. Even more remarkably, during
years with the highest equity share -- i.e., years such as 1929 and 1999 -- the
actual performance of the market averaged -6%. These results are inconsistent
with chance and the efficient market theory.
And the formula says … 19% this year
Putting
exact magnitudes on the relations, the professors derive the following line of
best fit:
Next
year’s return = 23% - (2/3 x percentage of equity/equity plus debt issued)
Thus,
if the percentage were 6%, as it was last year, the predicted return would be
19%.
The
usual way that academics evaluate their “fit” with the data is a ratio called
R-squared. This measures the increase in forecast accuracy that could be made
using the equation relative to a naïve extrapolation based on the average
upward drift in the stock market.
R-squareds
of 2% and 3% are normal for equations of this nature, but in this particular
case the R-squared is a whopping 12%, the highest that we, or the professors,
have seen. The indicator’s accuracy compares favorably with the standard academically
vetted methods of developing yearly forecasts of the market based on book
value, dividend yields and short-term interest rates.
As fundamental as supply and demand
Baker
and Wurgler’s results seem to us partly related to something even more fundamental
than shrewd decision-making by corporate executives: supply and demand. The
greater the potential supply of equity, the lower the future return. The lower
the potential supply, the higher the future return. Our book, "Practical
Speculation," contains numerous examples of other areas in which supply
and demand play the deciding role. For example, the percentage change in
initial public offerings and equity vs. money market funds show similarly
negative relations between supply and future returns.
There
is no such thing as a free lunch in the market. Baker and Wurgler ended their
study in 1997, and the indicator’s performance since then has been lackluster.
For example, in 2001, the equity share was at 6%, indicating a return in 2002
of 19%. As we all know, the market went down 23% in 2002.
And
yet, investors should keep in mind these two highly important things from the
Baker/Wurgler paper:
Final note
The
complete data set is available on our Web site. We are pleased to provide some
thoughts on supply and demand from University of Florida finance professor Jay
Ritter, author of the work on IPO supply we spoke of above:
"For
the stock market, price changes are determined by FLOW supply and demand, but
price levels are determined by STOCK supply and demand. If a company, or
trader, suddenly dumps a large number of shares on the market, the price will
fall in the short term. How much it falls partly depends upon how much
marketing effort is put in. Companies selling shares usually hire an
underwriter and conduct a road show, so that there will be flow demand when the
flow supply comes to the market.
The
marketing of stocks is why companies feel that analyst coverage is very
important. It is not clear that analyst coverage has much effect on the
aggregate stock market, but if an individual wants to increase his or her
investments in stocks, the person is more likely to buy a stock that a
stockbroker is recommending. This demand boosts the price of this stock
relative to the price of other stocks that are not covered.
When
the aggregate supply of shares is lowered through, for instance, share repurchases,
the whole market will have a higher price due to the reduced number of shares.
How big the impact is depends on how many investors are willing to substitute
between stocks and bonds rather than following mechanical asset allocation
rules such as 50-50 stock-bond allocations no matter what the level of the
stock market.
At
the time of publication, Victor Niederhoffer and Laurel Kenner did not own
shares of any of the equities mentioned in this column.