Could a Torrent of IPO’s Soak Your Portfolio Soon?

Up to 60 Initial Public Offerings (IPO’s) could flood the equity market with $250 billion of new supply during the second quarter.  With cash levels low, mutual funds may be forced to sell big name stocks hurting your portfolio in the second quarter.

The month of April has been a model of consistency for the stock market, as it has recorded positive investment returns over the last 10 years, 20 years, and since 1950. That does not mean every April has provided investors a profit. But compared to May, June, August, and September, April is a shining star. One of the main reasons for the good performance in April is money flows into individual retirement accounts (IRA’s) to capture the tax deduction for contributions. Much of the contributions go to mutual funds that then deploy the inflows into stock purchases lifting the S&P 500.

This year the headwind coming from a tsunami of Initial public Offerings (IPO’s) could swamp the inflows from IRA contributions. It is estimated that up to 60 IPO’s could come to the market in the second quarter with a chunk of them arriving in April. In total, the torrent of IPO’s could flood the equity market with $250 billion of new supply during the second quarter.

Who Is Going to Buy All That New Supply?

When the S&P 500 is rising, more money flows into equity funds as investors become more positive and chase returns. When the news is good and the market is going up, you feel more comfortable investing. After the S&P 500 bottomed in late March 2018, you can see how inflows tracked the trajectory of the S&P 500 almost perfectly.

If you have been investing for any length of time, you know how hard it is not to become emotional when the stock market is plunging. Many investors can’t stomach a gut wrenching decline so inflows often turn into outflows, when the S&P 500 experiences a decline. That’s what happened in the fourth quarter of 2018. During the sharp decline in the fourth quarter, outflows from equity funds rose, which caused the cumulative equity flows (blue line) to fall.

Despite the significant rally in the S&P 500 since the low in December 2018, investment flows into equity funds has been a trickle. This suggests that the amount of cash held by mutual funds is low, which could create a liquidity problem for equity funds that want to participate in the coming IPO’s. If a mutual fund doesn’t have enough cash on hand to buy an IPO, it will have to sell a portion of its existing holdings to fund the purchase of any IPO. This could cause an increase in selling, especially in stocks that have rallied the most since December.

Through March 15, U.S. companies bought $253 billion of their own stock, according to data compiled by Catalyst Funds. This large source of demand for stocks certainly contributed to the massive rally in the first quarter. However, most companies are not allowed to buy back their stock for a period of time around their quarterly earnings release.  This ‘blackout’ window will affect more than half of the companies in the S&P 500 from April 7 through April 21, and won’t fall below 20% of the S&P 500 until May 7. During this ‘blackout’ window, buybacks by companies won’t be able to offset any selling by mutual funds that need to raise cash to buy an IPO. This suggests that selling by mutual funds could have a bigger impact on the stock market during the ‘blackout’ window.

What does this mean for your portfolio?

The battle between IPO supply and demand from mutual funds and stock buybacks could make it more difficult for the stock market to provide the positive returns it has in previous Aprils in the past 10 and 20 years. If the forward guidance for the second and third quarter, provided by companies as they report their first quarter earnings, is not upbeat and rosy, stocks could be vulnerable to some selling and profit taking after such a great start to 2019. April is normally a shining star for portfolios, but May and June have not been portfolio friendly in the last 10 and 20 years. (See first chart). Even if the market manages to hold up during April, the coming supply of IPO’s in May and June could soak your portfolio.

When you drive your car, you keep your eyes focused on the 100 feet in front of your grill. The technical indicators I review in every Weekly Technical Review will help guide you as we approach what could prove to be a tough period in May and June. You wouldn’t drive your car with your eyes closed, would you?

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