Author: Barry Randall, Crabtree Asset Management
Covestor model: Crabtree Technology
Pop quiz: How many companies are in the Wilshire 5000 Index?
Before I get to the answer, let’s have a look at this classic benchmark, which was established in 1974 by Wilshire Associates, a financial consultancy based in California. The Wilshire 5000 (“W5000”) was designed to reflect the movement of the entire stock market, and as such is supposed to be comprised of all the stocks actively traded on U.S. stock exchanges.
When the W5000 was created, it was so-named because there were about 5,000 names traded on the major U.S. exchanges. These included the NYSE, the AMEX and the NASDAQ (then known more widely as the Over-The-Counter market). But the number of companies listed on the exchanges has fluctuated materially in the last 38 years. For the first 20 years or so of the W5000’s existence, the number of listings rose, peaking at 7,459 in 1997. By then, 15 years into a bull market, and five years into the Internet era, companies were going public or being spun-off at an unusually high rate.
But since then, the number of issues on major U.S. exchanges, and by extension, in the W5000, has declined markedly. So much so that as of today there are only about 3700 constituent listings in the W5000 (data courtesy of financial author Rick Ferri).
Why does this matter? Because the price of everything is determined by supply and demand. Yet in all the recent discussion about how the market is “due for a correction” and is “over-valued” and “gotten ahead of itself,” the impact of supply and demand on stock prices is virtually never heard.
But isn’t it realistic to assume that the $15 billion (per Strategic Insight) in net inflows into stock mutual funds in the first two months of this year needed to be put to work – i.e. used to buy new positions or increase existing ones? And that figure doesn’t even include the $43 billion (up from $18 billion in the year-earlier 2-month period) of net inflows into exchange-traded-funds, which continue to take share from traditional mutual funds?
In other words, any discussion about past price stock price movements (or estimates of future price movements) has to start with an honest accounting of a) investment inflows and outflows (i.e. demand); and b) the supply of stocks into which that risk capital flows. You can curse Fed Chairman Bernanke and worry about QE3 and start sweating first quarter earnings. But I think it’s more honest to frame the current discussion this way:
- The number of investable stocks listed on U.S. Exchanges is roughly half that of 15 years ago.
- The investing public, scared off (for good reason) by more than 10 years of burst bubbles, financial crises and bad actors is only now committing risk capital in substantial amounts for the first time is five years.
- The worldwide bond market remains structurally close to its peak (i.e. 0% short-term interest rates in the United States). If the consensus is that the opportunity in equities is greater than that in fixed income, then the flow of money out of bonds and into stocks will by definition be substantial, because the total worldwide bond market is $80 trillion, roughly double that of the worldwide equity market.
We cannot predict how the forthcoming earnings season will go, and here at Crabtree we don’t make investment decisions on such predictions anyway. But we are acutely aware of the recent trends in the supply of equities and the demand for them, as measured by actual fund flows. And a clear-eyed analysis of those two factors reveals that the market is unusually levered to changes in demand. And that demand has outweighed supply for U.S. equities during the first quarter of 2012.
In fact, thanks to the huge reduction in both the number of investable stocks as well as the number of shares outstanding, the market is probably far more volatile than a VIX of 18 or so would suggest. What’s more, that trend is likely to continue. For example, the forward P:E on the S&P 500 is about 13.5; that is, on an earnings basis it’s yielding 7.4%. When good credits can borrow at 3%, they’re going to play that trade for all it’s worth. IBM’s doing it: when they’re not buying other companies, they’re buying their own stock at a supersonic clip: their share count has dropped by 26% since 2005.
So what does the fact that the Wilshire 5000 is really the Wilshire 3700 telling us? Up or down, it’s going to be a bumpy ride. Fortunately, we traffic in technology stocks so we’re used to it. But while we wait for Q1 earnings to arrive, we’ll cinch up our seat belts and top up the oxygen bottle just in case.