To understand why the stock market continues to be bullish despite the slowdowns in American productivity and in corporate profits, you have to go back to the old law of supply and demand from Economics 101. When the supply of something decreases while the demand for it stays up, its price rises. Here, I'm talking about supply and demand in publicly traded stocks.
In case you hadn't noticed, corporate America and Wall Street are in the process of privatizing a growing portion of America's stock market. It's happening in two ways. First, cash-rich companies are finding they can boost their stock prices faster by buying back their shares of stock than by investing in new factories, equipment, or R&D. After IBM announced it was repurchasing another $15 billion of its stock last month, for example, the value of its publicly traded shares rose.
Meanwhile, private equity firms are doing a record amount of leveraged buyouts -- that is, taking publicly traded companies private. That's what Cerberus Capital did two weeks ago with Chrysler.
Look at the big picture. Last year, corporate buybacks and leveraged buyouts totaled about $600 billion. That was roughly 3 and a half percent of the whole value of the American stock market. At the rate buybacks and buyouts are going this year, the total is going to be close to about $900 billion. That's another 4 and a half percent of U.S. market capitalization taken out of circulation.
With the supply of publicly-traded shares shrinking like this, and with lots of global money out there to buy the shares that remain, it's no wonder the stock market is going gang busters.
Yet at some point this bubble will burst. You see, the whole reason for companies buying back their shares, and for private-equity firms doing leverage buyouts, is to put all these shares of stock back on to the public market at some point in the future, at a higher price than before.
But if stock prices are now rising largely because the supply of publicly traded shares is shrinking, and corporations are not making long-term investments, what happens when all this stock comes back on the market?
The loud thud you'll hear will be the sound of shares falling back to earth.