A Record Year for IPOs
This year has been a good year for a number of reasons: Covid vaccines rolled out, allowing most of us to get back to mostly normal life. Investors also made good returns on stocks, with markets near all-time highs, as corporate earnings recovered and interest rates stayed low.
Another record already set for 2021 is the number of IPOs in a year.
A record number of IPOs
In the past we’ve written about the lack of companies coming to public markets and how hard it is to compete with well-funded private equity markets – to the detriment of most households in the U.S.
But this year is different. We have already blown past the previous records for IPOs set in the 1990s, with almost 1,000 companies coming to market already this year.
Chart 1: Record IPOs, helped by SPACs, and strong valuations
Which made us wonder – what has changed?
We looked at whether the current low interest rates might have spurred companies to go public – but in the ‘90s, rates were much higher. It wasn’t inflation either, which has generally been falling throughout the whole period.
However, the peaks in valuations (PE ratio and IPOs align quite well (Chart 1, blue line. That makes sense – it’s more attractive for an issuer to go public when valuations are stronger. That, in turn, is an argument to ensure our markets have low costs of capital and minimal trading frictions.
The other fact helping 2021 numbers is the growth of SPACs, which are arguably “future IPOs” (included in the yellow bar in Chart 1.
Importantly, SPACs are already publicly listed. That helps bring private companies public faster and allows public investors access to markets previously only available to accredited investors.
This is not the ‘90s tech bubble
Importantly, this year is different from the tech bubble in a number of ways.
Most importantly, in the ‘90s, inflation was around 3%, and real interest rates were positive at around 6%.
In contrast, at the start of this year, inflation was around 2%, and real interest rates were negative, with the 10-year yield remaining below 2% even as inflation started to increase.
The importance of that can be seen if we plot PE ratios vs. interest rates over time (Chart 2).
All of the blue dates follow a curve, where lower interest rates support higher valuations. That makes sense from a valuation perspective too. Lower interest rates lead to future cashflow discounting less – leading to higher valuations. From another perspective, a company with a 5% profit margin is a much more attractive investment when long-term borrow costs are less than 2%, as they are now than when it costs 5%-7% to borrow money back in the ‘90s.
Although market valuations now are high (orange circle), we are not that far from the grey trend line, indicating that low rates mostly support current valuations.
In contrast, the purple (tech bubble) dates had the same PE as now but much higher interest rates.
Chart 2: Low rates support current valuations better than the ‘90s
However, as we end 2021 with inflation running well above target levels, there is an expectation that interest rates will rise soon. That has already been pushing the orange dot toward the right during the year.
Historic PEs don’t include future earnings growth
In order to stay near trend, the PE ratio is expected to fall – known as multiple compression. But the PE ratio can fall in one of two ways.
- Stock prices can fall, or
- Earnings can grow.
One thing that historic PE ratios also miss is future earnings growth.
Recent earnings data shows that U.S. companies are, in fact, growing earnings strongly (Chart 3, grey line). That growth in earnings is so far stronger than the multiple compression caused by rising rates (blue line), helping to support this year’s rally (green line).
Chart 3: And earnings are currently rising, helping support historic PE multiples
What does this all mean?
Low rates have been great for investors, supporting valuations and helping grow the list of companies in public markets.
However, one reason to watch inflation and the Fed’s response to our strong underlying economy is that it affects interest rates. And that, in turn, could create headwinds for stocks in 2022.
It’s also a reason to watch earnings closely, as they could keep offsetting margin compression.
Although strong earnings mean companies are raising prices to maintain margins, and that supports longer-term inflation. It is likely a factor that contributed to Fed Chair Jerome Powell retiring the word “transitory inflation” earlier this week.