Could The Alibaba IPO Be The Trigger For A Stock Market Crash?

Ok ok – I plead insta-guilty to headline exaggerations, but the concept in this post is an essential one that I’ve discussed before: new issuance (ie: IPOs) is a factor that actually alters “cash on the sideline” – a concept which confuses so many people.

I contemplated reprinting the post I wrote on this topic for Facebook ($FB – no positions), but instead I’ll first try a slightly different explanation.   First, let’s review a few realities:

1) the Cash on the Sidelines Fallacy:  some people get confused when they see increasing amounts of cash on a certain market segment’s balance sheet*.   They then conclude “this cash will get “put to work,” resulting in higher stock prices.”  This is a fallacy because when you spend cash to buy stocks, someone else raises an equal amount of cash selling that same stock to you.    The “cash on the sidelines” doesn’t change, it just moves from one account to another.   Another way of putting it is that money doesn’t flow into or out of the stock market, it flows through the market.

2) Sometimes, however, there are exogenous sources outside of the market ecosystem described in the above paragraph that can alter the balance between cash and shares.   When a company buys back stock, it removes shares and injects cash:  it simultaneously decreases the supply of shares available to “the market” while increasing the amount of cash held by “the market.”   On the flip side, when a company sells stock in an IPO, it increases the supply of shares available to “the market” while simultaneously decreasing the amount of cash held by “the market” (because that cash comes out of “the market” and goes to the company that sold the new shares in the IPO.

So anyway, Alibaba’s roadshow kicks off today, leading up to what will be the largest IPO in U.S. history (in terms of amount of stock sold, which is the relevant point for this post)**.

When Alibaba sells $20-something billion dollars of stock, they’ll be altering the cash/shares balance in the market ecosystem by increasing supply of shares and decreasing the supply of cash.   Economics 101’s supply and demand curves tell us that in a vacuum, this means that prices of shares need to adjust (lower) or demand for shares needs to adjust (higher) to equilibrate (or maybe some of both: decreasing prices result in increasing demand, etc).  If you want to read more about how some models use these changes in supply and demand to try to quantify market action, Trimtabs models the effects.

Does this mean that Alibaba selling $20-odd billion dollars of stock will cause a stock market crash?  Of course not, but it could be a headwind for The Market for the next few weeks***.   If you go back and look at how U.S. markets performed around the Visa ($V – no positions), General Motors ($GM – no positions) and Facebook ($FB – no positions) IPOs, it’s probably no accident that there were some selloffs leading into the offerings.****

 

Related: Facebook’s IPO and the Cash on the Sidelines Fallacy

Renaissance: Largest U.S. IPO’s (By Deal Size)

-KD

 

* I put a little footnote here because I think that the key is that different market segments might have different propensities to dispel themselves of cash balances.   Ie, mutual funds may be more eager to rid themselves of cash (by buying stocks) than retail investors are.  After all, their job (the mutual funds) is generally to own stocks…

** It may also, when all is said and done, be the largest IPO ever, globally, once the Greenshoe over-allotment option is accounted for.  Additionally, it will likely be the largest valuation for an IPO (subsequent market value of the company) ever.

*** It’s worth noting that Alibaba is selling roughly 1/3rd of the shares in the offering, Yahoo ($YHOO – no positions) is selling roughly 1/3rd, and other shareholders are selling roughly 1/3rd.

**** Although one could easily add that the market action around the Visa offering was more related to the macro financial crisis that was unfolding.   Similarly, the “selloff” around the General Motors offering was tiny – less than 2%.   The market (S&P 500) sold off by roughly 100 points (7%) into the Facebook offering.

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