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The
Speculator
The best market
indicators out there
Basic economics of
supply and demand can help you spot the market trends ahead of
the crowd. Here are 7 places to look for
them.
By Victor
Niederhoffer and Laurel Kenner
After writing more than 170 consecutive
weekly columns from the firing line here over the last four
years, during perhaps the most apprehensive and exciting
period in market history, we have come to our penultimate
article. Some questions arise: Does our work amount to
anything more than an aimless recording of market moves? Do
our predictions -- sometimes accurate, sometimes terribly
incorrect -- represent anything more than historical
curiosities and ephemeral meals for a day? Or did we provide
some overriding principles, a grand theme that will continue
to serve our readers in illumining the future?
Looking
back over our work, we believe that the single most important
and helpful principle we’ve written about is the
bread-and-butter law of economics: supply and demand. Like a
musical motif in a symphony, supply and demand analysis
enlivens and enlightens every aspect of investment
decision-making.
Here, then, is how supply and demand
relates to some strong general tendencies in the markets. To
bring our writing to a close, we have developed some new
applications and permutations that build on our previous work,
together with enumerations of which companies are currently
affected by the workings of this principle.
IPOs: excellent indicator of
supply
Such simple things as the supply of initial
public offerings are great predictive indicators. Yearly
numbers show IPOs peaked in 1999 and 2000, with about $100
billion raised by the market in both years, up from an average
of $50 billion for the previous 10 years. It is no accident
that the performance of IPOs in 2000 and 2001 were down 45%
and 1.4%, respectively.
In 2001 and 2002, IPOs dropped
by some 60% to the $40 billion level. We predicted in our March 6,
2003 column that there would be a tremendous increase in
price for shares sold in the average IPO. The reason was
partly the reduced supply, but also the incredible aversion to
risk that investors develop when prices go down and sentiment
is bad. Such reductions in the demand curve raise the required
return that investors will demand as a condition of buying
IPOs.
The Bloomberg IPO Index, which measures the
performance of stocks during their first publicly traded year,
is up 23% year to date and now stands at 1,125, up some 130%
from its 1997 close and above where it ended October 1999, the
highest it had ever been before its astonishing millennial
surge to a peak of 2,372 on March 10, 2000.
Secondary offerings: smart timers
One good indicator of supply -- indeed, very
informed supply -- is the dollar amount of secondary offerings
issued during a year. When the supply of secondary shares is
large, the market is ready to go down. Based on our studies,
we have come up with a new indicator based on secondary
offerings.
We’ve compiled a list of secondaries by
month for the last 12 years. It varied from a low of $252
million in August 2002 to a high of $32.9 billion in September
1997. Note that the high occurred near a top of the market and
the low occurred near a market bottom. Quantifying the
relation, we found that the best predictor of the market based
on secondaries is:
Market’s % change = 1% less 2/1000 times the % change of
secondaries in a month
For example, if the amount of
secondaries increases 100% in a month, the predicted change in
the S&P 500 ($INX)
is:
1% less 2/10 = 0.8%
This correlation between the
predicted market movement and the actual movement is about 17%
-- a level that would occur by chance approximately 10 times
out of 100.
Secondaries are down in August from
approximately $7.5 billion in July to $5.5 billion. Thus, the
best prediction for September’s S&P 500 move is slightly
higher than its norm of 1% a month.
Individual secondary offerings: a warning
sign
The same principle can be applied in
considering individual stocks. The key thing to remember is
that companies tend to issue additional shares at very
opportune times to sell. Here are the 10 most-recent
announcements of secondary offerings:
| Recent secondary
offerings |
| Company |
Announcement date |
Industry |
| Anteon
International (ANT,
news,
msgs) |
8/22/03 |
Computers |
| Pain
Therapeutics (PTIE,
news,
msgs) |
8/22/03 |
Drugs |
| August
Technology (AUGT,
news,
msgs) |
8/20/03 |
Semiconductors |
| Gables Residential
Trust (GBP,
news,
msgs) |
8/20/03 |
REIT |
| OGE
Energy (OGE,
news,
msgs) |
8/19/03 |
Electric |
| Pacific Energy
Partners (PPX,
news,
msgs) |
8/18/03 |
Pipelines |
| Intelli-Check (IDN,
news,
msgs) |
8/14/03 |
Electronics |
| Bell
Microproducts (BELM,
news,
msgs) |
8/13/03 |
High-tech distribution |
| AvalonBay
Communities (AVB,
news,
msgs) |
8/12/03 |
REIT |
| Regency
Centers (REG,
news,
msgs) |
8/12/03 |
REIT | |
IPOs vs. secondaries
Some types of
supply seem to be particularly potent in driving down market
prices. When more dollars are raised through IPOs than through
secondaries, the market is bearish over the next quarter.
Again using regression analysis, we developed a formula that
provides the best linear prediction of next quarter’s
percentage return in the S&P 500 based on the ratio of the
amount raised in IPOs to the amount raised in secondary
offerings:
7 - 5 ($ raised in IPOS/$ raised in
secondaries)
Say $80 billion is raised in IPOs and $20
billion in secondary offerings in a quarter. That’s four times
as many IPOs as secondary offerings Multiply 4 by 5 and you
get 20; subtract that from 7 to get the expectation for the
change in the S&P 500 Index in the next quarter: -13%. So
if you read that IPOs were abysmal at $4 billion and
secondaries were their steadfast $20 billion, the resulting
expectation is a gain of 6%, improbable as it sounds.
Right now, the expectation for
September-October-November is 4%, based on our formula and the
ratio of dollars raised in IPOs versus secondaries in June,
July and so far in August.
Lockup expirations
When a company
sells shares for the first time in a public offering, the
insiders -- officers, directors, financial backers -- often
agree to hold them for several months before selling. We
studied the last 3½ years of market history and found that
shares did worse than the market in times of oversupply and
better at times of low supply as the end of the lockup period
approached. As usual, the market performed its function of
anticipating shifts in the supply or demand curves and
adjusted prices accordingly.
| How stocks perform
when insider lockups expire |
| Year |
No. of lockup expirations |
Avg. performance 2 months
prior |
Performance vs. Nasdaq 100*
|
Avg. performance 2 months
after |
Performance vs. Nasdaq
100* |
| 2000 |
412 |
-24% |
-19% pts |
-9% |
-2% pts |
| 2001 |
203 |
-18% |
-7% pts |
-10% |
6% pts |
| 2002 |
74 |
-6% |
-3% pts |
7% |
13% pts |
| 2003 (through June) |
29 |
17% |
7% pts |
13% |
6%
pts | | *In percentage points
Source: Bloomberg
database of company filings; Niederhoffer
Management
A full workout giving details of each
company, its lockup date, its stock performance vis-à-vis that
of the Nasdaq 100 Index ($IQX)
for the periods in the table above is available at our Web
site, Daily
Speculations, under “Supplementary to
Columns.”
Four companies are scheduled to end their
lockups in the next three months: Endurance Specialty
Holdings (ENH,
news,
msgs);
Telkom (TKG,
news,
msgs);
Chungwa Telecom (CHT,
news,
msgs)
and iPayment (IPMT,
news,
msgs).
Reducing supply with buybacks
When
companies buy back shares, reducing the number of their
outstanding shares, the stock rises. Here are the 10 largest
buybacks announced this year by S&P 500 companies,
classified by percentage of outstanding shares
involved:
| Buybacks announced
in 2003 ranked by % of outstanding capital |
| Company |
% of outstanding capital
reduced |
| Andrew (ANDW,
news,
msgs) |
15% |
| Waters (WAT,
news,
msgs) |
13% |
| Circuit City
Stores (CC,
news,
msgs) |
13% |
| AutoNation (AN,
news,
msgs) |
12% |
| Brown-Forman (BF.B,
news,
msgs) |
12% |
| Anheuser-Busch (BUD,
news,
msgs) |
12% |
| Bear
Stearns (BSC,
news,
msgs) |
11% |
| National
Semiconductor (NSM,
news,
msgs) |
11% |
| Washington
Mutual (WM,
news,
msgs) |
11% |
| Lehman
Brothers (LEH,
news,
msgs) |
10% | | Source: Bloomberg, Niederhoffer
Management
Equity and
debt
One of the best indicators of market
performance we’ve come across is based on the percentage of
equity issued by corporations in a year relative to the total
amount of capital (equity plus debt) raised. The lower the
percentage of equity in a given year, the better the
stock-market returns in the following year. We noted in our April 10
column this year that the predicted return for 2003 would
be 19% based on the formula, which was developed by Malcolm
Baker and Jeffrey Wurgler, a pair of 20-something Harvard grad
students who have since gone on to professorships. At the time
of our article, the inclusive Wilshire 5000 Index ($TMW.X)
was up 1%. Four months later, it is up 15% year to date, not
far off the mark. As we wrote in our article, “The time to buy
is when the supply is low.”
Why
it works
Let’s step back to reflect on what
underlies all of these indicators. It is axiomatic that the
price of any good is determined by supply and demand. For our
purpose, stocks are the good. If the price of a stock goes up,
the quantity planned to be supplied will go up. If the price
goes down, the quantity planned to be supplied will go down.
The reverse is true for the quantity demanded. If the price of
a stock goes down, the quantity demanded will go up. This is a
consequence of scarcity. In order to get one good, you have to
give up something else. People will wish to buy more of a good
if they have to give up less of something else.
The
percentage change in the quantity supplied or demanded that is
caused by a given percentage change in price is called the
“elasticity.” For example, if a 1% increase in the price of a
stock were to cause a 10% increase in the amount supplied, the
elasticity would be 10.
Most economists believe that
the elasticity of stocks is very high -- that a very small
decrease in price will elicit a very large increase in demand.
The idea is that all stocks of the same risk class are perfect
substitutes for each other. So, if a stock goes down in price,
the holders of similar stocks will see a bargain and rush in
to buy at a profit. Since arbitrage of this nature would be
very profitable, decreases like that aren’t ever
seen.
If this reasoning were correct, it would be very
easy to sell big blocks of stocks at a small concession, since
the quantity demanded would increase at the lower price.
Speculators like us believe the contrary: that an increased
supply exerts an enormous impact on price. Too many times, we
have had to sell just a few thousand shares of a stock and
found its price wallowing at its lows -- just until we get
out. As soon as we have sold, the stock shows a spectacular
rise.
Academic studies on supply and demand in the
market support the practitioners’ view that the demand curve
for stocks is not highly elastic. In the market, you have to
pay more for things than you can sell them for; that is known
as the bid-ask spread. Furthermore, stocks have been shown to
go down when additional supply comes on the market around such
events as block sales, lockup periods, secondary offerings and
issuance of shares to pay for acquisitions. Conversely, stocks
rise when the number of shares is reduced by events like
tender offers and buybacks. A good summary of these studies is
provided in “Equity Issues and their Impact on Stockholders’
Wealth,” a June 1997 paper by Matej Blasko of the University
of Georgia, Athens.
Every trader
has anecdotes that support these academic studies. When we
started writing together in 2000, around the peak of the
Internet-stock boom, we were greeted by an astounding signal
of oversupply. In just one weekend, Vic received proposals and
business plans for no less than seven Internet-based
companies, including one from each of his two oldest
daughters, two from his merger partner in Atlanta, one from a
professor in criminology and two unsolicited over the Web.
“When supply does catch up to meet demand, prices have a way
of coming down,” we wrote. “Such an abundance of supply
waiting in the wings cannot be bullish for the Internet
stocks.” If poor Vic, bereft in luck and funds, was being
solicited with such enthusiasm, imagine what was coming over
the transoms of the heavy hitters. We turned the anecdote into
a highly bearish prediction for Internet stocks in a March 6,
2000, column on TheStreet.com and were eased out forthwith
from the Internet publication we wrote for. The Internet stock
index kept by that same publication peaked three days after
our column ran.
We hope we’ve helped you spot the law
of supply and demand as it plays out in the marketplace. Join
us here for our final column next week, and please visit our
Web site,
where we lay bare our regressions, scatter diagrams and data
under “Supplementary to Columns.”
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