Don’t Get High on Someone Else’s Supply

• Some Financials are issuing new shares of stock to raise capital. While markets are generally lauding such moves, increasing the supply of publicly traded shares can in fact be a negative for stock prices.
• Just like prices for other goods and services, stock prices move up and down based on the laws of supply and demand. Holding demand constant, increasing stock supply means lower prices.

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(Editor's Note: MarketMinder does NOT recommend individual securities; the below is simply an example of a broader theme we wish to highlight.)

Led by UBS's announcement to seek roughly $15 billion in new capital via new share issuances to the public, Financials shot up as a category today, as did global stock markets.

UBS Seeks Fresh Capital Injection, Expects $19 Billion in Write-Downs

By Katharina Bart, The Wall Street Journal
https://online.wsj.com/article/SB120702674576879869.html?mod=hps_us_whats_news

Given strong demand for these new share offerings, some are declaring the worst of the credit/liquidity crisis might be behind us. And maybe it's true, but it probably has little to do with share issuances. Strong demand for new shares of beleaguered Financials is a sign of robust capital markets and recovering confidence. But just beneath the surface is a fundamental and potentially insidious problem—increased stock supply.

Don't get us wrong, we dig a market rally as much as anyone. But share issuances increase stock supply and increasing supply is generally bad for stock markets in the longer run. Let's face it—the laws of supply and demand are boring. For some, it recalls torturous memories of trudging through Economics 101, where supply and demand are discussed in the context of "widgets" and other abstractions. But boring or not, supply and demand determine prices for all goods and services, including stocks. If there are more shares of stock available and demand remains constant, prices will fall. The reverse is also true. Another way to think about it is at the company specific level: Earnings per share decreases if the number of shares available increases, making the price of the new total of shares worth less than before.

In itself, this is a negative for stocks. But what's truly insidious about this is that markets are widely misinterpreting the event as a good thing.

The last time we saw precipitous share growth was 2000—the threshold of a big bear market. But today's environment is a far cry from that. Today the capital is being raised for legitimate and temporal reasons—to avoid systemic failure—unlike 2000, which was driven by stock-based mergers, IPOs, and euphoric sentiment to the tune of hundreds of billions.

Luckily, the magnitude of recent supply increases isn't large enough to wreak havoc on shares. Also, the new issuance is concentrated in one sector—Financials. But many other sectors are experiencing share count shrinkage—such as Energy, Materials, and Technology. M&A and share buyback activity should continue to ballast share issuance and destroy stock supply. The net result is restrained share growth, if not mild shrinkage. Take, for example, IBM's ginormous share repurchase announcement in February.

IBM Plans $15 Billion Share Buyback
By Staff, Reuters
https://www.nytimes.com/2008/02/27/technology/27blue.html

Once sentiment calms, we believe the fundamentals are in place for continued supply destruction. Today's announcements of share issuances were well received by investors and likely reflect recovering confidence in capital markets, but we'd caution them to not get too high on someone else's supply—stock supply, that is.