Stock Market– Record Increase in Supply Meets Extreme Risk Aversion

By: Paul_L_Kasriel

Equity prices, like the prices of everything, are determined by the interaction of supply and demand factors. The latest flow-of -funds data from the Federal Reserve have an interesting factoid on the supply-side of the equities-price equation. In the fourth quarter of last year, net issuance of domestic corporate equities totaled $986 billion at a seasonally-adjusted annual rate - a record dollar amount of issuance (see Chart 1). This also was a record issuance relative to nominal GDP - 6.9% (see Chart 2).

Chart 1

Chart 2

Who was doing all of this issuing? Chart 3 shows us that it was the financial system, desperate for new capital to replace a huge amount of old "depreciated" capital, that was doing all the issuing. At a seasonally-adjusted annual rate, financial institutions were net issuers of equity to the tune of $1.4 trillion in the last year's fourth quarter while nonfinancial corporations were net "retirers" of $450 billion of equity.

Chart 3

At the same time the financial institutions were issuing record absolute and relative amounts of new equity, I think it is safe to say that investors' demand for financial institutions' equities was somewhat inhibited. Chart 4 shows that the yield on AA-rated debt issued by financial institutions was rising sharply in both absolute terms as well as relative to AA-rated debt issued by industrial corporations. If investors were becoming much more risk averse with regard to financial institutions' investment grade debt, it stands to reason they were more risk averse with regard to financial institutions' equity capital.

Chart 4

In sum, there is no mystery as to why the broad U.S. stock indexes took a dive in the fourth quarter of last year. It simply was a matter of an increase in supply accompanied a decrease in demand.

Paul Kasriel is the recipient of the 2006 Lawrence R. Klein Award for Blue Chip Forecasting Accuracy

By Paul L. Kasriel
The Northern Trust Company
Economic Research Department - Daily Global Commentary

Copyright © 2009 Paul Kasriel
Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005.

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