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Using IPO Trends To Time The Stock Market at Trader’s Narrative

If you know anything about Wall St. you won’t be surprised to learn that the cyclical nature of IPO trends can be studied to gain insight into the stock market.

After all, companies don’t go public as a gesture of charity. They do so because they think that they will gain something by exchanging their shares for your money. A transaction occurs when the two sides agree on the price but disagree on the value of the asset in play.

But there is an inherent asymmetry when it comes to IPOs. Although we have put in place measures to protect the public (through circulars, public disclosures, etc.) the insiders still know much more about their company and its merit as an investment than the general public who are taking the other side of the deal.

So obviously when we have an avalanche of insiders wanting to sell to the public, they aren’t doing so because they want to hand over their hard earned capital out of the goodness of their hearts. You know that valuations are so out of whack that they are about to soon regress to the mean. This is what happened in early 2000 - when you had people taking everything short of their daughter’s lemonade stand public.

The current market environment is very different from then. That is why I’m just not persuaded by the dire predictions of mass market meltdown or financial armageddon. We are actually enduring a severe IPO drought.

To play Devil’s advocate, today’s lack of IPOs may be partially explained by the low interest rate environment. Financially strong companies can turn to the fixed income market to find funding at lower cost of capital than equity markets. But I don’t think that explains it completely.

After the jump there is a great article written by Mark Hulbert for the NY Times which goes into more detail about several research studies which look at the predictive characteristics of the IPO market:

A Sign of Hope for Stocks By Mark Hulbert

From at least one perspective, the stock market peak of last October was not accompanied by the speculative excesses found at the height of previous bull markets. This raises hope that the market decline that began in the fall may not turn out to be severe — and that it may have already run its course.

The indicator in question focuses on corporate money-raising. Considerable research has shown that when companies turn aggressively to the equity market for their financing needs, through new issues or secondary offerings, it is a sign that the stock market is overvalued. Though there is no easy way to interpret the data, current trends in corporate finance appear no worse than neutral for the stock market’s intermediate-term prospects. And the data may actually be painting a bullish picture.

Owen A. Lamont, a former finance professor at Yale and now a fellow at its International Center for Finance, has studied shifts in companies’ use of the equity market to raise money. He has constructed a gauge, which some have called the new-list indicator, based on the percentage of all publicly traded shares that began trading in the trailing 36 months. This proportion increases as new companies go public or already-public companies issue more shares, and decreases as companies engage in stock repurchases or mergers and acquisitions.

Professor Lamont, who is also a portfolio manager at DKR Capital, a hedge fund in Stamford, Conn., has calculated the new-list percentage back to 1929. Its all-time high was nearly 15 percent, at the beginning of the Depression. Its second-highest level, almost 11 percent, was in March 2000, just before the Internet bubble burst. (He published these results in 2002 in an academic working paper.) [ You can find the paper in the free trading resource section, under Reports & Articles: “Corporate Events and Market Timing”]

Where does the new-list percentage stand now? In an interview, Professor Lamont said it was at 5.1 percent, or right in line with its long-term average. When the market hit its high in October, he said, his indicator stood at just 5.6 percent. That was only marginally higher than where it finished the year, and about half its level at the market top in March 2000. By this measure of speculative activity, the current market is markedly less overheated than it was before the bursting of the Internet bubble.

A related and even more encouraging indicator focuses on the relative proportion of new corporate cash that comes from equity as opposed to debt. Researchers have found that in past periods when stocks were overvalued, companies greatly preferred equity over debt. The opposite tended to be the case when stocks were undervalued.

Two researchers who have studied these patterns are Malcolm P. Baker, a finance professor at Harvard Business School, and Jeffrey Wurgler, a finance professor at New York University. For each year from 1927 through 1996, the professors calculated the share of total capital raised by publicly traded corporations that came from issuing stock — what they call the equity share.

Over the 12 months after the quartile of years with the lowest equity shares (when this proportion was no higher than 14 percent) the stock market returned an average of 14 percent, according to the professors. In contrast, the market had an average net loss of 6 percent following the quartile of years with the highest equity shares (when this proportion was no lower than 27 percent). Their results were published in the October 2000 issue of the Journal of Finance. [You can find the paper in the free trading resource section, under Reports & Articles: “Equity Share in New Issues and Aggregate Stock Returns”]

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