This one signal says a stock market correction may be on the way

Consider these troubling signals from the IPO market.

1. Ominous volume: Second-quarter IPO proceeds were the biggest since — get this — the fourth quarter of 1999. The huge tech selloff that scarred a generation of investors started in March 2000 and then spread to the entire market.

Some details: A total of 115 IPOs raised $40.7 billion in the second quarter. That follows a busy first quarter when 100 IPOs raised $39.1 billion. Both quarters saw the largest amount of capital raised since the fourth quarter of 1999, when IPOs raised $46.5 billion. These numbers come from the IPO experts at Renaissance Capital, which manages the IPO exchange traded fund, Renaissance IPO ETF IPO, -3.43%.

Of course, adjusted for inflation, the 2021 numbers shrink relative to the fourth quarter of 1999. But this doesn’t get us off the hook. The 2021 IPO figures, above, exclude the $12.2 billion and $87 billion raised by special purpose acquisition companies (SPACs) in the second and first quarters.

This spike in IPO volume is troubling for a simple reason. Investment bankers and companies know the most opportune time to sell stock is around market highs. They bring companies public at their convenience, not ours. This tells us they may be selling a top now.

Here are the other ominous signs of froth in the IPO market.

2. Tech leads the way: It dominates the IPO market again, just as in1999. The tech sector raised the majority of second-quarter proceeds and posted its busiest quarter in at least two decades with 42 IPOs, says Renaissance Capital. This included the quarter’s largest IPO, DiDi Global  DIDI, +1.61%, the Chinese ride-hailing app. The large U.S.-based tech names were Applovin APP, -5.54% in app software, the robotics company UiPath PATH, -3.68%, and the payments platform Marqeta MQ, -4.93%.

3. We can expect more of the same: A robust IPO pipeline sets the stage for a booming third quarter, says Renaissance Capital. The IPO pipeline has over a hundred companies. Tech dominates.

4. Frothy first-day gains: The average first-day pop for IPOs in the second quarter was 42%. That’s well above the range of 31%-37% for the prior four quarters.

5. Historically high valuations: Typically, tech companies have come public with enterprise-value-(EV)-to-sales ratios of around 10. Now many are coming public with EV/sales ratios in the 20-30 range or more, points out Avery Spears, an IPO analyst at Renaissance Capital. For example, the cybersecurity company SentinelOne S, -6.14% came public with an EV/sales ratio of 81, says Spears.

6. Retail investors in the mix: They’re big participants in IPO trading — often driving IPOs up by crazy amounts in first-day trading. “In the second quarter there were a lot of small deals with low floats and absolutely insane trading, popping well over 100% and in one case over 1,000%,” says Spears. Pop Culture Group CPOP, -12.38% rose over 400% on its first day of trading, and E-Home Household Service EJH, -3.67% advanced 1,100%. “This demonstrates presence of retail investors in the market,” she says. Both names have since fallen.

Keep in mind that the 2000 selloff was not the only one foreshadowed by IPO froth. The selloffs during mid-2015 to early 2016 and the second half 2018 were both preceded by high-water marks for IPO deal volume.

IPO-froth pushback

“It’s different this time” are maybe the most dangerous words in investing. But market experts say several factors suggest the robust IPO market isn’t such a negative signal.

First, decent quality companies are coming public. “Because companies stay private longer, you are seeing far more mature companies coming public,” says Todd Skacan, equity capital markets manager at T. Rowe Price. These aren’t like the speculative Internet companies of 1999. “It would be more of a signal of froth if more borderline companies were coming public like in the fourth quarter of 1999,” he says.

We saw some of this with the SPACs, says Skacan, but the SPAC craze has cooled off. Second-quarter SPAC issuance fell 79% compared to the first quarter, muted by “investor fatigue and regulatory scrutiny,” says a Renaissance Capital report on the IPO market. In the second quarter, 63 SPACs raised $12.2 billion, compared to the 298 SPACs that raised $87 billion in the first quarter.

Next, the type of company coming public might also calm fears. Alongside all the tech names, there are many industrial and consumer-facing companies — not the kinds of businesses that indicate froth. The latter category includes public national brands like Mister Car Wash MCW, -1.82% and Krispy Kreme DNUT, -2.16%, and the high-growth oat milk brand Oatly OTLY, -2.79%.

Third, IPOs are only floating 10%-15% of their overall value, and many post-IPO valuations are not that much higher than valuations implied by pre-IPO capital raises. That’s different, compared to 1999. “It is not like they are selling a high number of shares at inflated prices,” says Skacan. This makes sense, because companies that are more mature when they do an IPO don’t need as much money.

Liquidity flood

“I think it says more about general liquidity than it does about where the stock market is going next,” says Kevin Landis of the Firsthand Technology Opportunities  TEFQX, -3.24%, referring to the IPO frenzy. “There is so much money sloshing around. The capital markets look like the rich guy from out of town who just got off the cruise ship, and we are all coming out of the woodwork to sell him stuff,” he says.

“Things are going up simply because of liquidity, which means eventually there will be a top,” says Landis. “But not necessarily an impending top right around the corner.” Landis is worth listening to because his fund outperforms his technology category by 9.6 percentage points annualized over the five years, according to Morningstar.

The bottom line

Market calls are always a matter of what intelligence spies call “the mosaic.” Each bit of information is a piece of an overall mosaic. While the IPO market froth is disturbing, you should consider this cautionary signal as just one among many.

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned APP. Brush has suggested APP in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks,