Falling number of shares a key factor behind the market rally

By: Raul Elizalde
today's photoWhen a stock pays a dividend rate higher than the interest at which the company can borrow money, it makes sense for that company to issue debt and buy back its own stock. This is exactly what happened as interest rates fell to historic lows. We believe that the retirement of equities is a key factor in the stock market rally, making them look “expensive” when compared to traditional measures of value, but not when considering their shrinking supply.

We measured changes in the number of outstanding shares of about 350 stocks with an aggregate market capitalization of $17.4 trillion (the total market is currently around $28 trillion). We found that since the beginning of 2011, the number of shares dropped by about 8%. If those shares had not been retired, this group would have a $1.7 trillion larger market capitalization. This extrapolates to a $2.8 trillion shortfall for the total market of US equities due to corporate buybacks.

image 1This estimation is remarkably similar to the $3.0 trillion retired equities calculated by the Federal Reserve. In addition, the Fed tallies the value of shares retired due to mergers and acquisitions, which adds up to another $2.3 trillion, for a total of $5.3 trillion in that period. This was only partially offset by $2.9 trillion of new issues coming to market. On balance, therefore, corporate America retired $2.4 trillion of equities value, which is on par with the GDP of the United Kingdom.

image 2This has vast implications. Stock prices go up disproportionately to the number of shares retired, meaning that a 1% reduction in supply causes a price appreciation much larger than 1%. More precisely, the marginal change in price due to the marginal change in supply is very high. This effect is not easy to isolate and measure, but it is undoubtedly present, and we believe that it is an important factor behind the market rally.

It also helps explain why equities seem expensive against traditional measures of value, such as P/E ratios. A corporation finds value in buying its own stock if it reduces its cost of capital, regardless of what those indicators show. The fact that top management compensation is often linked to the price of their stock may also play a role in a company’s decision to repurchase stock.

As long as this activity continues, the market will continue to seem “expensive”, and it may become more so if the Trump administration’s attempts to reduce the corporate tax rate eventually succeed.

Many US corporations with profitable global operations have not brought back those funds because they are subject to taxation once they come in. According to Moody’s, non-financial US companies hold close to $2 trillion abroad. If a corporate tax cut persuades companies to bring back their overseas profits, the likelihood is that they will be used to repurchase company stock. It is quite doubtful, as proponents of the tax cut argue, that they will be invested in their respective lines of businesses. Given that businesses have easy access to historically cheap credit, money sitting abroad does not seem to be a hindrance to financing any investments that seem promising.

Most recently, both our numbers and the Fed’s numbers show a slight decline in the pace of equity retirement. It could be “noise”, or it could be due to the modest interest rate rise of late last year.

It is reasonable to assume that if interest rates or equity prices go up much further, the economic benefits of retiring shares will end. The danger of higher rates is small, in our view, because it is difficult for the Fed to justify lifting rates much more when inflation has been falling further and further away from its target. As much as the Fed wants to “normalize” monetary policy, hiking rates when inflation is falling is risky.

On the other hand, earnings-per-share have been climbing, both on a trailing and (especially) on a forward basis. Moreover, Europe looks stronger and global GDP projections have improved. These fundamental factors support higher equity prices everywhere, regardless of the impact of corporate demand for equities.

These fundamental factors could make equities seem less expensive in the medium term when compared to traditional measures of revenue and earnings, and could well spur a new wave of demand from retail investors who, because of low interest rates, have few other places to go for returns. The market rally will end one day, but the combination of corporate demand, improving fundamentals, benign outlook for rates and a potential for growing retail demand are pushing that day further into the future.

What now?
We are a Registered Investment Advisor held to a fiduciary standard of care. We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances, and we always put their interests first. That means we do not profit from transactions or by selling any products. Our only compensation is based on the assets we manage, which goes a long way of aligning our interests with yours. We can also help you evaluate your current goals and establish an investment plan aiming at achieving steady, long-term returns while managing downside risk. You can download our report describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more.

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Raul cropped for facebookRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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Raul Elizalde Selected as Contributor for Forbes.com Investment Blog

Raul cropped for facebookRaul Elizalde, President and Chief Investment Officer at Sarasota-based Path Financial LLC, has been selected as a guest columnist for Forbes.com, where he will regularly contribute to financial writer Lawrence Light’s investment advice blog. Elizalde’s first Forbes’ contribution was published May 23, 2017, on the topic of “Private Debt Mounts: Why We Should Be Worried,” and may be viewed at https://www.forbes.com/sites/lawrencelight/2017/05/23/private-debt-mounts-why-we-should-be-worried/#11f50b453c56.

Elizalde is also a contributing blogger under his own byline for Investopedia.com, and his economic and investment analyses have been published online by some of the most respected financial media in the country, including Morningstar, Motley Fool, the Street and Yahoo! Finance. He shares his insights monthly through Path Financial’s subscriber-based, electronic newsletter, Straight Talk (http://www.pathfinancial.net/contact.html).

Light is an award-winning journalist with a distinguished career that includes editorial and contributing writer positions with The Wall Street Journal, Forbes, Business Week, Money Magazine, and AdviceIQ.com website. His work has also appeared in Barrons, Fortune, Investopedia, Huffington Post, Yahoo Finance and more. In addition to his Forbes.com blog he covers the financial aspects of the Trump White House for CBS MoneyWatch.

Path Financial is a Florida-registered investment firm, partnered with preferred account custodians Charles Schwab & Company and TD Ameritrade. Path is rated “A+” by the Better Business Bureau, and is located at 1990 Main St., in Sarasota, Florida. For more information, call 941.350.7904 or connect at http://www.Facebook.com/PathFinancial.

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Path Financial Expands Investment Advisor Team

Oxana Saunders Vice President Path FinancialSarasota-based investment advisory firm Path Financial, founded by president and chief investment officer Raul Elizalde, has named Oxana Saunders as vice president. Ms. Saunders will focus on business development, client relations, and portfolio management; she holds a NASAA Series 66 Investment Advisor Representative license and joined Path in early January 2017. Together, the two senior executives provide clients with 47 years of investment expertise honed during their respective careers on Wall Street.

Ms. Saunders will work with new clients to provide investment advice based on their life goals and personal circumstances. She is available to speak to individuals and organizations on a variety of investment-related topics, including helping clients better understand family investments, and how individuals can protect assets in times of life transition. Initial consultations are complimentary; Oxana Saunders may be reached at 941.894.2571, and oxana@pathfinancial.net.

A graduate of Baruch College with a degree in Finance and Investments, Ms. Saunders enjoyed a successful career on Wall Street prior to relocating to Sarasota in 2016. She began her investment banking career at Lehman Brothers (later Barclays Capital), where she rose to the position of Senior Vice President and was responsible for distributing a full line of products to U.S. institutional investors. She was instrumental in propelling the bank to the top of industry surveys, and was later was hired by Deutsche Bank to expand its client base. Her clients included first-tier financial institutions such as Alliance Bernstein, Oppenheimer Funds, and T Rowe Price.

“Ms. Saunders is a consummate professional with tremendous experience and intimate knowledge of financial markets,” stated Mr. Elizalde. “Throughout her career, she has made it a priority to help her clients and put their interests first. I am delighted she has joined Path Financial.”

Path Financial is a Florida-registered investment firm, partnered with preferred account custodians such as Charles Schwab & Company and TD Ameritrade. Path is rated “A+” by the Better Business Bureau, and is located at 1990 Main St., in Sarasota, Florida.

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