Shrinking stock market could fuel rising gains

Wall Street's growing legions of analysts might have overlooked one reason the stock market has risen in recent years: The U.S. stock market itself is shrinking.

At the end of last year, 5,008 stocks traded on U.S. exchanges, down 44% from a peak of 8,884 in 1997, according to the World Federation of Exchanges. Similarly, there were only 3,776 stocks in the Wilshire 5000 stock index, the broadest gauge of the U.S. equity market, which also peaked in 1997, with 7,459 stocks.

What's more, the number of outstanding shares of stock available to be bought or sold has shrunk by nearly 10% since the end of 2010, according to S&P Dow Jones Indices.

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The upshot? Some investment strategists say more money chasing fewer stocks has created a supply-and-demand dynamic that is supportive of higher stock prices.

"The de-equitization of the markets may stand as perhaps the most unheralded reason for all of the rapid rise in stock prices since 2009," Jason Trennert, founder of Strategas Research Partners, told clients in a research note.

The reasons for the shrinking number of stocks in the U.S. are many and date to the dot-com stock crash of 2000.

By the end of 2000, nearly 1,000 fewer companies were trading compared with 1997. The big drop was caused largely by fledgling tech companies going out of business. Every year in the 2000s saw a decline in the number of listed stocks. The number of stocks exiting exchanges picked up steam following the 2008 financial crisis and the Great Recession, when close to 1,000 more stocks disappeared from exchanges, according to the WFE.

That steep drop was due in part to fewer companies going public, with investor fear, as well as rising costs, increased scrutiny and more stringent regulations from the federal government, cooling the market. Back-to-back market meltdowns in the past decade took a toll on the initial public offering market. In 2000, a record 406 companies went public, a! ccording to Renaissance Capital. But the market for IPOs, which went dormant from 2001 to 2003, dried up again in 2008 and 2009.

Many companies concluded that it simply wasn't worth it to go public.

The current environment has had a negative impact on the appetite for IPOs, says Terry Sandven, chief equity strategist at U.S. Bank Wealth Management.

The decline in listed stocks is also due to private-equity firms buying publicly traded companies and taking them private, as well as merger-and-acquisition activity.

Do fewer stocks to buy add up to higher prices?

"The number of companies has declined approximately 40% since 1997," says Sandven. "With less supply, and if demand remains constant, it does provide an upward bias in equity prices."

Bob Waid, managing director at Wilshire Associates, however, doesn't buy the bullish supply-and-demand theory. Stocks rise and fall based on business conditions, he says.

"I would not say that what's driving the U.S. stock market up is fewer companies," says Waid. "At the end of the day, investors have to look at fundamentals. And prices have to include future dividends and earnings (streams)."