The stock market is changing.
Here is an important and remarkably stylized fact that many investors are not aware of; the US stock markets have shrunk in size by more than a third since the year 2000. As a result, the number of publicly traded companies on the US exchanges is now roughly equal to the level last seen in 1990. In other words, the stock market that investors are facing today is dramatically different than the one they faced a decade ago in terms of the type of companies that are available for investment.
This shrinking stock market comes despite an economy that has nearly tripled in size during that period. The shrinking size of the stock market by number of public firms is also in stark contrast to the increasing total market capitalization of the overall stock market.
The decline in the number of firms is not solely a byproduct of the bursting of the 2000 dotcom bubble, nor the 2008 recession as the figure below shows. Instead, the decline has been measured and persistent for more than a decade beginning in the late 1990’s. The shrinking number of firms, but rising total equity value has resulted in growth in the mean firm’s size.
The shrinking stock market has important implications for investors, especially as the current mini-M&A boom seems set to continue - or even accelerate - under the new administration and companies can effectively repatriate foreign earnings.
There are two reasons why investors should care about the shrinking stock market. First it makes it harder to hold a diversified portfolio that is broadly representative of the overall economy. Second, if there are fewer firms then investors can pay more attention to each of those firms, making it harder to find undervalued below-the-radar assets. These realities forces investors to turn towards alternative investments like venture capital and litigation finance.
Over and above the investment implications, the shrinking stock market is also important because it impacts growth in the economy and potentially job growth as well – a key hallmark of the political environment right now. Small and medium-sized firms are often described as the engine of job growth, so if there are fewer firms with access to financing via equity markets, then that’s bad for the country as a whole.
The shrinking stock market also mirrors other trends like the fall in the number of dividend-paying companies and the fall in the number of IPOs each of which is also a potentially serious issue for investors. The proportion of dividend paying firms has fallen dramatically from 66.5% in 1978 to 20.8% today. The number of IPOs has slowed dramatically since 2000 (averaging 99 post-1999 vs. an average of 310 pre-2000). This result is driven by a greater propensity among small firms to sell out to larger competitors. Taken together with these two findings, one by-product of the shrinking stock market is that the marginal US publicly traded firm is now a later-stage, slower-growing company. And that in turn offers a partial explanation for the relatively resilient, but slow growth of the US economy over the last five years.
On the whole investors today don’t have the same opportunity set that they once did. There is no direct cure for this of course. International diversification can help, but country risk is something many investors just aren’t comfortable with. Instead investors need to accept the fact that the companies they are investing in today do not necessarily reflect the broader US economy for better or for worse. Accepting that and investing accordingly requires investors to shift their mindset and focus on what will make a particular large company successful rather than investing based on what trends are occurring in the broader economy.
Mike McDonald is a PhD in finance and a university professor in the subject at Fairfield University in Connecticut. He also runs a consulting company doing work on quantitative investing, big data, and machine learning for a variety of financial firms, asset managers, institutional investors, and government regulators. Prior to getting his PhD, Mike worked for a major Wall Street bank and one of the top hedge funds. Comments, questions, and concerns are always welcome – email Mike at M.McDonald@MorningInvestmentsCT.com or visit his firm’s website at www.MorningInvestmentsCT.com