America’s Incredible Shrinking Stock Market

656316_tape-measureInvestors have paid ample attention to the impact of innovation on stock markets in recent years, from exchange-traded funds to high frequency trading. However, we tend to focus much less on the shifting nature of the underlying firms and what impact that could have on equity market dynamics.

A new paper adds to the conversation by examining how significant changes in U.S.-listed companies and industries have impacted both stock performance and the overall market. In “The Disappearance of Public Firms and the Changing Nature of U.S. Industries,” Rice University’s Gustavo Grillon shows how a systematic decline in the number of publicly-traded firms has had a major impact on U.S. industries, which have become more concentrated as a result. His paper will be presented at the 2015 Northern Finance Association Conference in Banff (September 18-20).

Grillon points out that half of U.S. industries have lost over 50% of their publicly-traded peers. To put that in perspective, the number of firms listed in the U.S. today is now lower than it was in the early 1970s. And, back then, the U.S. real GDP was just a third of what it is now.

He also finds that the declining number of public firms has not been offset by other market factors such as a growing number of private firms to replace them.

The effects of this change have been widespread — the decrease in the number of public firms has affected over 90% of U.S. industries and while some might think that decline is due to changing consumer preferences or technological innovations, that is not the case.

Rather, the biggest driver in the decline of public firms is associated with meaningful changes in the corporate share of profits. Finds Grillon, there is “a strong association between the reduction in the number of public firms and the remaining firms’ profitability, stock returns, and investment opportunities as captured by M&A gains.”

This phenomenon has significantly changed the nature of public firms – and while it has generated higher profit margins and abnormal stock returns for U.S. investors, it comes at a cost. The changing drivers of U.S. product markets have lead to potentially weakened competition.

Read the full paper on the Northern Finance Association’s website.