The Equity Share in New Issues and Aggregate Stock Returns

The share of equity issues in total new equity and debt issues is a strong predictor of U.S. stock market returns between 1928 and 1997. In particular, firms issue relatively more equity than debt just before periods of low market returns. The equity share in new issues has stable predictive power in both halves of the sample period and after controlling for other known predictors. We do not find support for efficient market explanations of the results. Instead, the fact that the equity share sometimes predicts significantly negative market returns suggests inefficiency and that firms time the market component of their returns when issuing securities. IN THEIR CLASSIC PROOF of the irrelevance of financing policy, Modigliani and Miller ~1958! implicitly assume market efficiency. If the stock market is inefficient, however, financing policy becomes relevant in obvious ways. When equity prices are too high, existing shareholders benefit by issuing overvalued equity. When equity prices are too low, issuing debt is preferable. Consistent with this timing hypothesis, firms issuing equity have poor subsequent performance. Stigler ~1964!, Ritter ~1991!, Loughran and Ritter ~1995!, and Speiss and Aff leck-Graves ~1995! find low average returns after both initial and seasoned offerings. 1 These studies focus exclusively on issuer returns relative to some benchmark—the first term in the decomposition Ri 5 ~Ri 2 Rb! 1 Rb. The benchmark is typically the market portfolio or