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How Much Of The Stock Market's Growth Is Caused By Its Shrinking?

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There's a small cause-and-effect mystery in the interaction between share prices and share buybacks. On the one hand, when a company buys back stock, that should make the remaining shares more valuable, on reasoning both fundamental-ish (EPS is up!) and technical-ish (more buyers than sellers!). On the other hand, issuers seem to view their own shares as Veblen goods: the higher the price, the more they want to buy.1 So it's a little hard to know whether the market is reaching record highs (in part) because companies are spending record amounts of money buying back their stock, or vice versa. The first explanation mostly makes sense, and the second mostly doesn't, which is a good argument for the second being right.

The first explanation is more popular though. Today the Journal noted that "U.S. companies are showering investors with a record windfall in the form of dividends and share buybacks, helping to propel the stock market's rally," and FT Alphaville and others have been talking about de-equitization, as well as the declining attractiveness of listed public equity. So have I, come to think of it.

One possibly relevant question you could ask is: how much is the market shrinking? That seems susceptible to various sorts of answers, as well as various possibly relevant time periods. As it happens, tomorrow marks the four-year anniversary of the market's hitting a 15-year low, so mazel tov everyone on that. Here's perhaps a place to start measuring U.S. equity market shrinkage over those four years:

The orange line is the market cap of all publicly listed U.S. companies, currently about $18.3 trillion. The white line is a broad market-cap-weighted index of U.S. stock prices, currently about 1750 unitless units. As you'd expect, they're pretty close. But they're not the same; over the last four years overall, the market cap is up by 126% while the index is up by almost 138%. Back-of-the-envelope math shows $934 billion of "missing" market cap: if market cap had grown by as much as stock prices over the last four years, there'd be $934 billion more of it.2 That missing market cap is one rough measure of the total amount of share buybacks, going-privates, other cash-out mergers and recapitalizations, and I guess bankruptcies,3 net of new stock issuances.

There are subsidiary stories there as well: through mid-2011, market cap led stock prices, suggesting a story of re-equitization and hesitancy to commit to buybacks and M&A. Since then, the trend has reversed, with buybacks and M&A picking up and becoming more of a factor. $250 billion of that $934 billion comes in the last twelve months. Here's quarterly data going back to 2007:

Still market cap is up $10 trillion over those four years, so the $934 billion of market shrinkage is a pretty minor effect:

One lazy way to read this is: M&A and buybacks, net of new issuance, are responsible for about 9% of the last four years' bull market. The rest is economic fundamentals or animal spirits or QEinfinity or whatever your preferred explanation is. And if, as it probably does, your preferred explanation involves human optimism (well-founded, ill-founded, Fed-founded, or otherwise), then it probably applies to corporate treasurers as much as it does to other humans. So my guess is they're mostly buying back stock because stock prices are up, rather than the reverse.

Firms Send Record Cash Back to Investors [WSJ]
Ladies and Gentlemen, the Stock Market is Shrinking [Reformed Broker]
Buybacks, M&A, and de-equitisation and February the strongest month ever for US buybacks [FTAV]

1.Discussion question: Veblen goods, Giffen goods, or other? The Veblen-good case is something like "when the stock is up that makes you feel like you run an awesome company and why wouldn't you buy stock in an awesome company so you buy it." The Giffen-good case is harder to make out but has some appeal insofar as buying your own stock is sort of an inferior move versus like investing in your business: "are you out of ideas for how to use the money?," naysayers ask, etc. In any case here is a thing that Matt Yglesias said yesterday that is perfectly sensible economic theory but also surely false:

Most business investment is internally financed .... In principle, as share prices rise, [share repurchase] gets less attractive and [internal investment] therefore gets more attractive. That's the theory, at any rate. When stocks are cheap, firms buy shares. When stocks are expensive, they buy capital goods. We'll see if it happens in practice.

Hahaha sure we will:

2.The spreadsheet has some alternative measurements. I'm not satisfied with any of them really; Bloomberg's all-US-market-cap index doesn't have a corresponding price index, and the broad price indices either lack robust historical market cap data on Bloomberg (MSCI) or aren't that broad (Russell 3000, S&P 500). In particular the numbered indices (Russell 3000, S&P 500) will tend to increase in market cap with mergers: if the bottom two S&P 500 companies merge in a stock-for-stock deal, then another company will be added to the index, and the index's market cap will grow, even though the overall market's amount of equity has not. (Similar arguments apply in cash deals: the market's equity will shrink by the size of the cashed-out company, while the S&P's won't due to the offsetting affect of adding another company.)Which is not to say that the indices I use are perfect. The differences are a little worrying: the market cap of the S&P 500 increased by more, in percentage terms over the last four years, than the S&P 500 index did. If the S&P's market cap had only increased in parallel with the S&P 500 index, it would be $246bn smaller than it is today. Over the last year, though, the numbers are pretty unanimous: the market has shrunk by $100-$250bn no matter how you measure.

3.Nah, there the stock should be zero, right? Sort of.