If financial markets were perfectly efficient, they would be far less volatile than they are, notes Andrew Smithers of Smithers & Co in a client report on US equities and corporate supply and demand. While that may sound obvious, Smithers – as he often does – draws some interesting conclusions.
In practice, the markets seem to overreact to events, rising when news is better than expected and falling when it’s worse, he notes. Under certain conditions, however, this pattern is modified:
Mean reversion to value is one influence, but this is seldom strong in the short-term, particularly when markets are around fair value, as the US equity market is today. Another important influence is the ability and eagerness of management to buy-back shares. The increased use of incentives based on share price performance has increased the disparity between the interest of management and shareholders.
Until recently, such conditions have encouraged buy-backs and highly leveraged acquisitions by private equity, he notes. “As non-financial companies have pushed their debt ratios to all-time highs and, as banks today have neither the capacity nor the wish to expand their balance sheets, we anticipate a change in the behaviour of non-financial companies from being net buyers to net issuers of equity”.
Financial companies, meanwhile, particularly banks, are also looking to raise unprecedented amounts of equity. In 2009 the US federal government bought $256bn of equity in companies. But this level of support is likely to fall and, in time, reverse: Equity issues are difficult to make when markets are weak, notes Smithers. Equity supply from companies is thus likely to rise in response to periods of market strength. In this process they absorb liquidity and dampen the rise. This makes the US equity market more than usually vulnerable to disappointments.
If events are favourable and news is better than expected, markets would, in the absence of other influences, tend to rise. But, concludes Smithers, if one assumes that first, future news will be evenly balanced – ie, as often favourable as unfavourable; second, that companies will indeed change from being net buyers to net issuers; and third, that there are no unforeseen and major positive influence on the market, then the US equity market “has an above average chance of falling”.