Friday, December 29, 2006

Is the "Shrinking Market" A Reason for the Recent Rally

From CBS MarketWatch

For some observers, this bull market can be partly explained by the fundamentals of supply and demand: The supply, or number of shares outstanding, has declined while demand, in the form of investor optimism, has stabilized and recently begun to increase.

"The more you shrink it, the more it has the potential to rise, all other things being equal," said Rod Smyth, chief investment strategist with Wachovia Securities. "If you're shrinking the market with buyouts, you're putting money back into people's pockets, which in a bull market they're likely to keep re-investing in the market."

More than $400 billion worth of new cash takeovers have been announced this year, while companies bought back in excess of $600 billion worth of their own stock, both records, according to estimates compiled by TrimTabs Investment Research, a Santa Rosa, Calif.-based firm that tracks market trends for institutions.

Simple supply and demand indicates a smaller supply leads to a higher price. Here's a chart of the last few years that shows this year in perspective:

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I've been trying to figure out this rally for the last month or so. Stocks hit record highs during a strong expansion. Yet all of the macro-indicators indicate the economy is slowing. While the current evidence indicates a soft-landing is in place, there are still a few very large wild cards (oil, the dollar and housing) that could tip the US into recession. In short, the macro-numbers don't indicate we should be having stock market records.

The shrinking amount of shares plus the large amount of share buybacks has obvioiusly put a bid in the market.