Myriad trends may mean lower equity returns

The merger of the New York Stock Exchange and the Deutsche Boerse bodes ill for individual investors, not because ownership and the headquarters of the combined exchange will be outside the United States, but because of the trends that produced it. The long-term result of these trends may be that U.S. equity returns will be lower than in the past. The primary force driving the combination is the tremendous growth of derivatives trading and its immense profitability, as well as the decline of stock-trading profitability. Derivatives trading is the engine of profitability at both the NYSE and the Deutsche Boerse, with stock trading a minor contributor to earnings. Another source of revenue, listing fees, also has shriveled. In fact, the number of stocks listed on the NYSE has dropped by almost half since the mid-1990s. That decline is a result of a drop in the number of initial public offerings, mergers and acquisitions that reduced the number of listed companies, leveraged buyouts taking companies private and the delisting of failed companies. The traditional role of stock exchanges has been to facilitate the raising of capital by companies seeking to grow, to provide liquidity and price discovery for those wishing to buy or sell shares and to provide a mechanism for determining the value of whole corporations. Now the primary role of major exchanges seems to be to provide mechanisms through which large investors can buy or sell risk by trading derivatives. This change in emphasis has occurred because of changes in the regulatory and financial environment in which the exchanges operate. First, the profitability of stock trading for NYSE members plunged after 2001, when stock prices were quoted in cents rather than in sixteenths. The previous year, however, the NYSE had established the New York Futures Exchange to trade derivatives, thus providing another source of revenue. Second, globalization and the growth of other capital markets and exchanges provided increased competition for stock listings. Non-U.S. companies that once might have listed on the NYSE to gain access to U.S. capital now can find that capital elsewhere. Third, with more institutional investors making significant commitments to private-equity investments, startup companies growing beyond the venture capital stage can get the financing for the next stage of growth without going public. More successful startups are likely to delay going public. The reporting rigors of the Sarbanes-Oxley law have added to the incentive to remain private as long as possible, or to list offshore. Facebook Inc., which recently did a limited private offering, is likely to be the model for many companies. Startup companies will go public only when the high-growth period is over and the initial investors want to take some or all of their gains off the table. Thus, these large institutions, and some wealthy investors, will gain access to the high-growth periods of companies. In the past, most of these companies would have gone public soon after the VC stage, giving ordinary investors a chance to participate in the high-growth, high-return period. The implication of these trends for individual investors is that listed U.S. common stocks are likely to deliver lower returns from earnings growth than in the past. This could also be true for other developed markets. Investors and their financial advisers likely will have to work harder, consider more investment vehicles, reach into new markets and perhaps take more risk to earn the returns they have enjoyed in the past. Further, since investment returns might carry less of the load in preparing for retirement, investors should save more.