IPOs and Secondaries Surge

Alibaba’s IPO last week – which amounted to $21 billion in value – was the biggest in history. It was also wildly successful, as the stock surged by 38% on its first trading day. However, the US IPO market was already heating up before Alibaba’s debut: Q2 2014 saw the heaviest issuance since Q4 2007.

Recall that in spite of the fact that NBER later dated the beginning of the recession to Q4 2007, there was zero awareness that a recession might even be in store at the time. In October of 2007, shares in companies that would be bankrupt and in need of bailouts a few months later were still trading in the stratosphere (Fannie Mae’s common stock changed hands for $70, shares in mortgage insurer Ambac did likewise – the latter eventually fell to less that 2 cents). The opinion of the bien pensants at the time was that the “sub-prime mortgage credit crisis was well contained”, and the DJ Transportation Average even climbed to a new all time high in May of 2008. So Q4 2007 was definitely still a fairly good time to flog IPOs.

The time is even better now – in the wake of Alibaba’s IPO, 2014 is already all but certain to break previous issuance records. Here is a chart showing the pre-Alibaba situation as of Q2:

By Q2 2014, 160 IPOs had been issued – almost as many as in the 7 quarters Q1 2009-Q3 2010. 2011 and 2012 were relatively quiet years, but that has changed in 2013 as the market continued to surge. 2014 is well on its way to becoming a record year – click to enlarge.

As PwC reported on the Q2 2014 numbers:

“The market for initial public offerings (IPOs) finished on a strong note late in the second quarter of 2014, recording the highest quarterly deal volume since the fourth quarter of 2007. Interest in new equity issues is expected to remain healthy heading into the third quarter, driven by continued investor demand for growth and a strong equities market environment, according to IPO Watch,a PwC US quarterly survey of IPOs listed on U.S. stock exchanges.

According to PwC, there were 89 public company debuts in the second quarter of 2014, representing $21.5 billion in proceeds raised. On an annual basis, this represents an increase of 41 percent over the 63 public listings in the second quarter of 2013, and a 63 percent increase over the $13.2 billion raised. For the first half of the year, there were a total of 160 IPOs, generating $32.4 billion in proceeds compared to 97 IPOs totalling $21 billion in the same period the previous year.  The IPO market saw a spike in activity beginning in mid-June, with 25 IPOs (28 percent of IPOs) pricing during the final three weeks of the second quarter.”

Following on the heels of the successful Alibaba listing, the IPO calendar is brimfull. 11 IPOs and 2 secondaries are coming to market over just the first three days of this week, 3 of which are quite large, at $460 m. (ICL secondary), $1.1 bn. (AVAL secondary) and $3.4 bn. (CFG/Citizens Financial IPO) respectively. One doesn’t get a $21 billion IPO every day, so Alibaba is not necessarily the yardstick determining what should be called “sizable”.

Alibaba on its day of listing – priced at $68/share at its IPO, it ended the day at $93.89 – click to enlarge.

How Many Offerings Can the Market Digest?

If the IPO activity in Q3 so far is any indication, the market is facing quite a big surge in supply. So far, IPO activity was easily outgunned by stock buybacks in terms of value, but the money that funds buybacks isn’t growing on trees either. Much of it is borrowed, so at the very least one has to find investors willing to buy the bonds corporations issue to finance some of their buyback activity.

This was not particularly difficult hitherto, given that the domestic US money supply has increased by a cool $5 trillion since early 2008 (another $300 billion and the increase will amount to 100% since then), courtesy of the merry pranksters at the Fed.

However, as we recently noted, after hitting a record high in Q1, stock buybacks actually retreated somewhat in Q2. Usually it is held that a combination of declining buyback activity and surging offerings could eventuall weigh on the market.

However, while large stock buybacks definitely lend some support to the market by shrinking the overall share float, they always surge in conjunction with rising share prices and decline when share prices fall. So in a way they seem more effect than cause, as the managers of listed corporations apparently believe it is better to buy high rather than low, and the higher the better. Just as one can interpret large stock buybacks as bullish because they shrink the share float, one can state that a big surge in IPOs and secondaries proves that there is great demand for shares – after all, if demand were not exceptional, it wouldn’t be possible to price so many of them.

As with other investment assets, one cannot just employ a simplistic supply-demand analysis comparing new supply of stocks (IPOs) to the supply that is being retired (buybacks). After all, the vast bulk of the demand for stocks exists in the form of reservation demand, just as is the case with e.g. gold. Or putting it differently: the most important factor influencing the level of stock prices is the decision by current owners of stocks to either hold or sell at prevailing prices. The traders and investors at the margin who trade in the market every day are merely a mirror of the urgency of people to hold stocks rather than cash or vice versa.

It is not a case of demand exceeding supply, since demand and supply always balance – the number of stocks that are bought every day is exactly equal to the number that is sold. Rising prices only mean that buyers are prepared to pay more, and potential sellers aren’t prepared to sell unless they receive higher prices. This changing of hands of stocks and cash also makes all “money on the sidelines” arguments essentially useless. At the end of a trading day, the same amount of money is on the sidelines as at the beginning of it – only its ownership has changed (leaving aside the fact that additional money is created nearly every day by the Fed and commercial banks).

We would argue that a surge in IPOs and secondaries is indeed directly comparable to a surge in buybacks. Once it becomes extreme, it increasingly becomes a contrary rather than a confirming indicator. Along similar lines, the huge surge in margin debt that could be observed in recent years is also a confirming indicator until it hits extremes in terms of both absolute and relative levels (relative to market cap for instance). At that point it becomes a contrary indicator.

Real (CPI-adjusted) growth in the S&P 500 index and margin debt since 1995, via Doug Short. As an empirical datum, the speed of the surge in margin debt relative to the speed at which stock prices surge appears to be a contrary indicator as well – click to enlarge.

The question is now whether it is possible to gauge what levels of buybacks and/or IPO activity can be called “extreme”. Unfortunately there are no fixed yardsticks for this, given the continual change in the supply of money (which is almost always growing in the modern-day fiat money system, but not always at the same rate), as well as changes in the society-wide demand for money that occasionally happen.

So one has to consider all sides of the equation, and something that can be stated as a matter of empirical observation is that market peaks and peaks in IPO and buyback activity tend to occur after money supply growth has already been slowing down for some time. We are now in such a time period: money supply growth has begun to slow (see this recent chart), while buyback activity has achieved a record in H1 2014 (in spite of the slowdown in Q2, both quarters together have produced a record half yearly amount), while IPOs and secondaries are obviously surging at breakneck speed at present, both in terms of the number of offerings as well as of the value issued. Unfortunately this still doesn’t tell us when and from what level the market will succumb – it is merely another sign suggesting caution is increasingly warranted.

Conclusion:

The surge in IPOs is best seen as a sentiment indicator. It is not so much the absolute number of IPOs or their value that is important, but the fact that they are surging at an ever accelerating pace and hitting new records. In addition, this happens while the market (in terms of cap-weighted indexes) is trading near record highs and the vast money supply growth that has supported the boom is beginning to slow noticeably. A simple supply/demand analysis like that published by firms like TrimTabs cannot account for the reservation demand factor. It will be a change in this demand component that will bring about the next major trend change.

Charts by: PcW, StockCharts and Doug Short / Advisorperspectives