from Systems & Forecasts: Evidence that the Stock Market is Overheating
The current sentiment of the stock market is very positive, and equity sell-offs have been seen as buying opportunities in recent months. This optimism is raising the S&P 500 Index (a measure of the U.S. stock market) to record highs. … This week, I want to look at proceeds raised through Initial Public Offerings (IPOs) and how they may offer clues on the current state of the stock market.
Private companies in need of additional capital to expand their businesses often sell their company shares to the public (aka Initial Public Offering). A recent example of an IPO is Twitter. The company was created in March 2006 and the site was launched in July 2006. It went IPO on November 7th, 2013, and became a publicly traded company.
Another reason why companies go public is that IPOs enable early investors and company founders to cash out their investment.
Companies about to go public often initiate an IPO when stock market conditions are favorable because they may obtain a higher valuation for the stock sale. Did Twitter pick a good time for their IPO? Absolutely! The S&P 500 Index was up 24% (year-to-date) at the time of the IPO launch. So, what does an IPO have to do with stock valuation? Proceeds from IPOs tend to peak as the stock market peaks.
Chart 1 displays the proceeds raised from Initial Public Offerings for the last 11 years. As of November 13, the total proceeds raised through IPOs was $48 billion, which is little lower than $48.7 billion in 2007 (but it should surpass that by the year-end). These levels are much lower than in 2000 (the final year of the dotcom bubble) when companies raised over $108 billion through IPOs.
The two recent bear markets ended in March of 2003 and 2009. Recent IPO activity (2009-2013) is very similar to that of the previous stock market cycle (2003-2008). During the first year of the bull market (2003 and 2009), IPO activities were low and dramatically increased the next year. Proceeds generated from IPOs tapered off in the third year but bounced back the next two years. The similarity between the two periods is very staggering. 2013 is at similar levels to 2007 (which was the stock market top before the fall in 2008). This pattern is the basis of why I believe the stock market may be topping.
In addition to comparing the proceeds raised from IPOs for the two stock market periods, I also compared how equity prices have behaved since 2003 and 2009 (Chart 3). The S&P 500 Index rose sharply during the first year of the bull market (2003 and 2009) and then tapered off for next two years. During the fourth year, the index rose over 13% (2006 and 2012) but the S&P 500 Index rose much more sharply in 2013 than 2007, which may be attributable to the Fed’s commitment to keep long term interest rates low.
Private companies looking to go public tend to wait for a favorable stock market climate to maximize the capital raised through Initial Public Offerings. Yearly proceeds raised from IPOs during the 2003-2007 and 2009-2013 periods almost match exactly when the two periods are overlaid on top of one another. 2007 and 2013 were years with the highest proceeds from IPOs for the two periods above. If the past is a guide for the future, the stock market should not advance much higher from here (2007 was the stock market top and 2008 was a terrible year for stocks). Moreover, the S&P 500 Index performed similarly during the two periods except for 2007/2013.
Furthermore, the current P/E ratio of 19.46 for the S&P 500 Index seems too high even compared to 17.06 in 2007. I believe the next 5% selloff in the S&P 500 Index may progress to end up being a double-digit correction because of both an overvaluation of stocks and because proceeds from IPOs are approaching their highest levels since 2000 (too much optimism). While the stock market continues to rise, I would still exercise caution and not try to chase the rally. Try to stay the course with equity investment and enjoy the ride while it lasts but I would reduce equity exposure if the stock market sells off more than 5%. Lastly, 2014 may not be a good year for stocks (if 2008 serves as a guide after $48 billion raised through IPOs in 2007).
Joon Choi in Dr. Marvin Appel and Gerald Appel’s Systems & Forecasts, www.systemsandforecasts.com, 800-829-6229, November 15, 2013