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The stock market is shrinking. For investors, this is good news Add to ...

The stock market is shrinking.

Share buybacks, mergers and acquisitions, ultra-low interest rates and a weak market for initial public offerings have combined to take a big bite out of both the number of listed companies and the volume of outstanding shares in North America.

Shareholders have benefited from this trend, as less supply translates into higher prices. But eventually, investors are likely to get stung when central banks finally turn off the spigot of easy money and interest rates rise.

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Over the last 13 years, markets have almost always risen when the number of shares available to the public declines. Similarly, stock prices have been more likely to fall when the share float increases, says Charles Biderman, chairman of TrimTabs Investment Research in Sausalito, Calif.

The number of stocks comprising the broadest benchmark in North America has plummeted by almost half since 2000. The Wilshire 5000 Index is made up of 3,573 shares, down from 6,639 issues at the height of the dot-com boom.

Among the largest companies disappearing from the market this year are US Airways Group Inc., OfficeMax Inc. and H.J. Heinz Co. They’re being acquired by larger firms, which are being aided in their takeovers by interest rates that are far below historical norms. The low rates make it easier to fund acquisitions, and thereby reduce the number of companies on the market.

The shrinkage helps explain why stock markets have been strong during the last few years, even as institutions and individuals have generally diverted capital out of public equities and into bonds and alternative investments, says Don Stuart, a partner at Dixon Mitchell Investment Counsel in Vancouver.

The more widely followed Standard & Poor’s 500 index maintains a constant 500 members. But the actual number of shares those companies have available to the public decreased by 3.4 per cent between 2009 and 2012, says Howard Silverblatt, senior index analyst at S&P Dow Jones Indices LLC. (The figure excludes the financial sector, which was forced to issue millions of shares as part of a recapitalization effort during the financial crisis.)

“Fewer shares available, with the same amount of people going to buy them, pushes the prices upward, even if they are bad shares,” Mr. Silverblatt says.

Share buybacks are a big part of the phenomenon, with S&P 500 companies spending almost $400-billion (U.S.) last year to purchase their own stock. In fact, over the last decade the group has spent about 50 per cent more on buybacks than dividends. Those repurchases offset share dilution caused by stock-based compensation and dividend reinvestment plans, and in many cases actually reduce the outstanding share count. Apple Inc., for example, will reduce its float by as much as 15 per cent if it follows through on a recent announcement to spend up to $60-billion on buybacks.

Layered on top of shrinking markets is the artificial stimulant of quantitative easing by some of the world’s largest central banks. “The Fed is … creating money out of thin air at the rate of $4-billion a day. That money is looking to buy financial assets, but floats are not growing, so stocks are going up,” says Mr. Biderman, who manages the TrimTabs Float Shrink ETF, a fund that looks for companies that are shrinking their equity float and at the same time increasing their free cash flow. In the first quarter, it outperformed the S&P 500 benchmark by 4 per cent.

So what happens when the Fed finally turns off the spigot? “That’s another ball game,” Mr. Biderman admits. He expects the public float will rise as insiders bet that the party is over and begin cashing out their shares. At the same time, tighter monetary policy will make debt more expensive for companies, which will again find it more economical to raise money through the stock market.

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