The Equities Drought in the USA

Low interest rates, growing earnings confidence, deconstruction of the nanny state, tax cuts, broad based gains in 7 out of 11 industry sectors and low inflation are all contributing, but the commentary has missed the most important contributor to another new high for the Dow.

First, remember that the Dow Jones Index is price weighted not market cap weighted. The biggest contributors have been the highest priced stocks. The lowest priced stocks have been the smallest contributors. It’s a very concentrated list.

Secondly, the Russell and S and P 500 have not seen the same gains. The S and P was up 0.7 per cent today compared with 1.2 per cent for the Dow.

It’s a big cap high priced stock market in US based stocks.

Why is this happening? A big part of the gains is due to a shortage of equities. To repeat our commentary a week ago there is a shortage of quality equities due to buybacks, mergers and acquisitions, regulations that have strangled the public markets, and private equity which has starved the markets of new issues.

Why would anyone want to run the gauntlet of analysts and advisers who cannot see beyond the end of the week?

New IPOs are waiting longer and longer to list. The average time has extended from 8 years to more than 13 years. Private equity does not like being in a straightjacket. It dislikes stockmarkets.

The meltup that is occurring in the Dow is largely an American event. 

The number of available equity investments in the USA continues to fall while valuations continue to soar. Issued shares continue to shrink as mergers, buybacks consolidations, declining IPOs and ETFs squeeze out both institutional and private investors. Measured by the broad market indexes the value of US publicly traded equity is booming as a direct result of supply and demand for equities.

The numbers are interesting according to Craig Doidge, G. Andrew Karolyi, René M. Stulz, “The U.S. Listing Gap,” Journal of Financial Economics , March 2017

The number of US public companies is 3671 compared with 7322 in 1996 in spite of a doubling in GDP. The market cap of the 50 per cent of remaining stocks has doubled. The Wilshire 5000 index is 3500 companies, and 5000 in 2005. Individual ownership of stocks has dropped from over 25 per cent to under 20 per cent and by much more since 1976 probably from over 50 per cent. Hedge funds, buyout funds, index funds and venture capital are dominant in spite of the underperformance of many funds

In the USA we are already in a bear market for listed choice, diversity and opportunity that is being captured by private equity, crowd funding and importantly for investors, the handful of lenders and finance groups which support entrepreneurs. Look at any index and it is immediately apparent that most of the returns are being captured by the leading stocks. The best examples are Facebook Amazon Netflix and Google which have left everything else well behind.

IPos last year were 128 and 845 in 1996. The average age of companies going public is much older. Airbnb was able to raise $850 million in late stage venture capital funding in 2016 and is still not public.

US taxation laws continue to favour buybacks. There is no franking of dividends rather preferential rates for capital gains. If the past is any guide a planned reduction in the corporate tax rate to 20 per cent from 36 per cent will result in a wave of buybacks further reducing the supply of available equities which are not being replaced. Under the Bush tax cuts for repatriation the top 15 repatriating corporations increased spending on stock buybacks by 38 percent between 2005 to 2006 according to a Senate study in 2011.

Some would argue that is probably a good thing and the concentration of investment in a handful of leading stocks has led to stockbrokers being replaced by crowdfunding, private equity groups and lenders to small business who tie lending to equity performance. Outside the USA listings have increased by almost the same ratio that they have declined in the USA. Listings have dropped by about 50 per cent in the USA and risen by about 50 per cent in other developed markets since 1996. American Investors and regulators would argue that the quality of US listings have improved as a result of increased regulation. The ASX and other exchanges would argue that the quality of its listings has not declined.

All of this leads to the conclusion that diversification requires exposure to early and late stage venture capital which is out of the reach or skill sets of even some of the largest institutional investors. The unlisted T Rowe Price New Horizons Fund run by Henry Ellenbogen is a good example of a fund that invests in private equity deals. The opportunity is the gap between the common stock valuation and preference stock issued as the company expands. It has outperformed the leading BDCs in our tables below and the indexes.

Listed funds which are equipped to deal with private equity and whose valuations are governed by the markets include familiar names like Blackstone (not Blackrock). The symbol is BX.

here are the performance by share price for each of the seven listed US Funds Managers over the last 12 months

T Rowe Price 31 pct

Blackrock 27 pct

Brookfield 22 pct

State Street 19 pct

Blackstone 19 pct

Invesco 12 pct

Ben Franklin 5 pct