In the last nine years companies listed on US stock exchanges have been buying more shares than they have been issuing. In the last two years the numbers of available shares have fallen by 2.3%. This is not just due to stock buybacks. Mergers and takeovers have also reduced the number of stocks on can purchase. This discussion was brought to mind by the report in The New York Times Dealbook that Dunkin is about to go private. As Dunkin goes private, one more stock disappears from your stock trading options. How should one approach a shrinking stock market?

The De-equitization of the Stock Market

Business Insider discusses this problem in an article, Stock Markets Are Shrinking.

The US stock market has de-equitized, a fancy term that basically means that companies are buying more shares than they are issuing, every year since 2011. It’s shrunk 2.3% since 2018.
This is natural, according to Citigroup strategists led by Robert Buckland. “This is a rational response to a radical shift in the cost of equity and debt financing,” the team said in a note.
Meanwhile, a second equity market, one for private equity, is growing just as the public market is shrinking.

Much of this has to do with the cost of debt (cheap) versus equity (expensive). In other words, low interest rates have driven up the prices of stocks and made it a better deal to borrow money to buy out companies than to keep buying shares. This works both for companies buying back their stocks and for private equity companies buying whole enterprises.

An offshoot of this is that private equity companies are not going public as often or at all.

Why is this happening? Low interest rates are just part of the story. If a company wants to maintain its original purpose and direction, it needs to maintain its original core of ownership. This is hard to do when takeover artists threaten at every turn and investors come and go with a click on their Robinhood app. The need to sustain a stock price through thick and then can get in the way of long term goals. By keeping the core of ownership small, it is easier to manage a company. And, then all ownership is private, there are no stock owners who are their one day and gone the next.

On our sister site, Profitable Investing Tips, there is an article about whether or not you can buy shares of Space X. It turns out that your only option is to buy shares in Google in order to have access to a percent of so of the company. The reason is that the original investors want to go to Mars! They are not interested in being sidetracked from this goal if the company has a couple of bad years and the stock price falls.

Better for Companies and Worse for Stock Traders

So, it turns out that the falling numbers of shares of stocks makes good sense from the perspective of private investors and companies. Unfortunately, it does not make sense for folks who want to invest in or trade stocks.

We can expect this trend to continue so long as interest rates remain low and stock prices remain high. At that time it may reverse a bit. But, the desire for rich investors to maintain complete control of their destinies will not go away. Thus, the only profit that a trader might get is by accurately predicting when a company is about to go private and correctly timing their investment.

More and more retail investors are getting into the stock market. Unfortunately, many novices are also trading stocks and stock options. When is stock trading dangerous for novices? Investopedia writes about dangerous moves for first time investors. They note several things about first time investing or trading and what to watch out for.

Making the Same Stock Trading Mistakes

First time investors tend to make the same mistakes as their predecessors. They follow their emotions, invest in fads, follow tips without checking them out, choose too many penny stocks, and don’t know how to diversify. New investors are wise to limit their investing to money that they can afford to lose, start with small investments, and only increase how much they invest when they understand what they are doing.

This is especially true when trading stocks and options. A new investment option is the Robinhood app on your mobile device. More than ten million people, largely millennials use this way to invest. It allows you to make quick trades from your mobile device, avoid fees, and follow your trades throughout the day. Unfortunately, the company does not always place you in the best trade which is part of how they make their money. More importantly, the app works so fast that it becomes addicting. Too many young investors have seen early flashy profits only to find themselves in debt as their leveraged investments went bad.

When Is Stock Trading Dangerous?

Stock trading is dangerous when you don’t know what you are doing. Smart traders know how to set up their trades. They use tools like moving averages to decide when an investment is likely to be profitable. They understand that the fundamental or intrinsic value of a stock will eventually determine its price. As such they may execute a profitable short term trade and get out when they have seen a reasonable profit. They do not hand around hoping for more profit when they have no idea how that might happen.

Stock trading is a business and not a trip to the casino. Smart traders know how to use technical analysis tools to get into and out of their trades. They know the risks of letting fear and greed drive their trades. They treat each trade as a business deal, take their profit, and look for the next trade. They do not throw good money after bad by chasing losing trades in the hope of a turnaround. The fact is that many trades go bad for very solid reasons and hope has no part in the equation that is meant to lead to profits.

What Is the Right Price in a Stock Trade?

Buy low and sell high is the age-old rule when trading. But, when you are getting in at a low price, someone else thinks that the price will probably go lower. And, when you sell at a high price it is to someone who believes that the price will still go up. Learning when to buy and when to sell takes times and new traders are wise to start slowly, limit their trades, and learn as they go.

Stock traders need to know when stocks are priced too low, priced normally, or overpriced in order to time their trades. Today the market as a whole has recovered from the Covid-19 crash at the beginning of the year. Some stocks like the tech giants are thriving while others like airlines, tourism, hotels, energy, and others are still hurting. The real question for traders is if the market is priced too high and ready for a big correction. True, the stock market is excessively priced according to normal measures like the P/E ratio but not so bad if you use an output gap adjusted P/E. This implies that the current rally has room to run.

How Accurately Value Stocks Today

Market Watch writes that the market may be at a more reasonable valuation than many believe. As evidence, they cite the output gap adjusted P/E as opposed to the standard P/E ratio.

Nontraditional ways of assessing how pricey stocks have gotten may be warranted, given the nature of the biological disaster that helped to spark the rout in markets back in March.

They cite the output-gap-adjusted P/E multiple, or OGA P/E, which calculates the percent difference between the current level of real gross domestic product and its estimated potential level if the economy were operating at full employment and adjusting the trailing P/E based on the degree to which the output gap trails the average since 1950.

The point of their discussion is that once the virus has been beaten back by medications and vaccines, employment will likely resume at higher levels and production will go up substantially. If this is indeed the case, the output gap adjusted P/E ratio is a more accurate indicator of the relative value of the market today than a standard P/E ratio.

How Successful Will a Vaccine Be in Restoring the Economy?

We believe that there is some value to the variation in calculating the P/E ratio to get an accurate view of true stock values today. However, the current optimism is largely based on the assumption that one or more of the many vaccines under development today will save the day. This optimism misses the fact that as many as a third of Americans will not take a vaccine when it becomes available according to polls! Another issue is that no vaccine has passed the third phase of FDA-required trials. We would like to assume that vaccines will start becoming available by the end of the year but if you look back to the rush to produce a vaccine for the Swine Flu back in the 1970s you see that there were thousands of cases of Guillain-Barre Syndrome (total body paralysis) that were caused by the virus. Thus we are waiting for results of phase 3 testing to be assured that any or all of the vaccines are indeed safe to use and likely to help prevent the disease.

If the vaccines work and the GDP roars back to normal levels, the output gap adjusted way of measuring P/E ratios may be a better indicator of the true forward-looking value of stocks today.

A common argument for electing a Republican president is that Republicans are “pro-business” and Democrats are not. But, if you look at how the stock market has responded to administrations going back to Truman, you see a different story. Assuming that Biden’s lead in the polls translates into a victory in November, how will the market respond to a Biden presidency? To get a clue about how the market responded to both brands of politics, we looked at the numbers.

Stock Market Results with Both Democrats and Republicans

As a hint, the market tends to do better under Democrats! Here is how the S&P 500 did under presidents from Truman to Trump.
Democrats

• Clinton: Up 210%
• Obama: Up 182%
• Truman: Up 87%
• Johnson: Up 46%
• Carter: Up 28%
• Kennedy: Up 16%

Average: Up 95%

Republicans:

• Eisenhower: Up 129%
• Reagan: Up 117%
• Bush I: 51%
• Trump: Up 43%
• Ford: Up 26%
• Nixon: Down 20%
• Bush II: Down 40%

Average: Up 44%

How Will the Market Respond to a Biden Presidency?

We expect to see some selling this fall if it becomes clear than Biden will win. However, a greater driver of stock prices going forward will be profits. The tech sector continues to lead the market with earnings although Microsoft just fell a few percent on less-than-hoped-for earnings. The corona virus pandemic coupled with a Republican hesitancy to continue with economic stimulus payments will drive down spending and may hit hard at the end of the Trump presidency. If there is a wholesale change in governance with a Democratic majority in both houses of congress as well as a Democratic president we expect to see massive spending on infrastructure projects that will last for years. With interest rates likely to remain low for some time this will not be a drag on the economy and will stimulate spending and growth across the board.

If the market takes another hit at the end of the Trump presidency, there will be nowhere to go but up for the next administration. This would be a picture similar to the Bush II to Obama transition where a 40% fall off in the S&P 500 left lots of room to grow over the following years.

Investing, Politics, Pandemics, and the Economy

We believe that the biggest driver of the economy and the markets over the next months and years will be the covid-19 pandemic. To the extent that governments do well in managing this crisis, their economies and their stock markets will prosper. To the extent that governments adopt a “head-in-the-sand” approach like an ostrich, there will be trouble. We are seeing this now in the USA, Mexico, and Brazil where leaders have neglected this issue in hopes that it will just go away. This will be burden on these societies and their governments going forward. When, hopefully, a vaccine becomes available it is essential that people get the vaccine as patriotic duty as much as to protect themselves and their families. To the extent that this does not happen it will make little difference who controls the Oval Office and the halls of Congress.

The stock market overall has recovered from the “covid-19 crash” and is back to record highs. Is the market high sustainable or are we set for another crash? Is this because there is a wall of money that needs to be invested or because investors are expecting a V-shaped economic recovery and quick profits? Forbes looks at this very issue of unsustainable highs. Although most concerns about the prices of stocks have to do with fundamentals such as the likelihood of a decade-long recession, Forbes looks at technical factors in making their point about the sustainability of the market high. They suggest the use of stochastics in trading today. The bottom line of their discussion is to be wary in today’s market.

Risk Management in a Risky Stock Market

Market Watch agrees with the opinion that there is lots of risk in today’s market. Specifically, they have suggestions to help traders handle election and virus fears.
Proper risk management has the following elements that need to be orchestrated correctly:

• Holding a large amount of cash.
• Putting on hedges or more cash for those who do not want or can’t hedge.
• Putting on protection band(s).
• Owning good long-term positions based on fundamentals.
• Owning short to medium-term tactical positions.
• Following proper diversification based on sectors, strategies, time frames, correlations and geography.
• Holding short positions for those who are sophisticated and experienced or in the alternate inverse ETFs.
• Employing judicious use of stop losses or changes in allocations.
• Learning how to differentiate between strategic and tactical actions.
• Booking some profits as signals are given.
• Following reliable sources of technical, fundamental and macro analysis.
• Staying nimble.

These folks are more focused on how a Biden presidency would affect taxes, especially taxes on short term capital gains for stock traders. And, they seem to be putting the likely long term effects of the virus on the back burner as an issue that could affect investing sentiment rather than an issue that could tank the US economy for more than a decade to come. But, in either case, they agree that the current market highs may not be sustainable and that traders will be wise to manage their affairs accordingly.

Where Is the Money Coming from and Where Will It Go?

In a recent interview the head of the San Francisco Federal Reserve Bank said that the stimulus actions of the Fed were done to support credit markets and were not having an effect on the stock market. Nevertheless, there seems to be a lot of money floating around that wants to find a home rather than being held as cash. Over the long term the stock market has always been the best place to invest. However, getting in at market highs means you will commonly suffer losses that will take years to recover. Traders as well as investors will be wise to hedge their bets, sit on cash (like Warren Buffett is doing) and wait a bit until the future looks a bit clearer.