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SAN FRANCISCO (MarketWatch) -- 2006 was the year of the incredible shrinking stock market, when a record amount of shares left public markets amid a flurry of leveraged buyouts and share repurchases.

If the supply of equities continues to dwindle and retail investors also rediscover their former penchant for U.S. stock mutual funds, it could mean the market in 2007 would get a significant push higher, some strategists said. Still, others are dubious about the benefits of the recent LBO boom and warned that an unexpected spike in interest rates next year could derail stock markets.

The U.S. stock market is on course for its best year since 2003, with the Standard & Poor's 500 Index up more than 13% through Dec. 28. The benchmark has climbed for four straight years and recently hit six-year highs.

For some observers, this bull market can be partly explained by the fundamentals of supply and demand: The supply, or number of shares outstanding, has declined while demand, in the form of investor optimism, has stabilized and recently begun to increase.

"The more you shrink it, the more it has the potential to rise, all other things being equal," said Rod Smyth, chief investment strategist with Wachovia Securities. "If you're shrinking the market with buyouts, you're putting money back into people's pockets, which in a bull market they're likely to keep re-investing in the market."

In 2006, a pair of record-setting factors took a major chunk of supply off the market.

'The more you shrink it, the more it has the potential to rise, all other things being equal.'

â�” Rod Smyth, Wachovia Securities

More than $400 billion worth of new cash takeovers have been announced this year, while companies bought back in excess of $600 billion worth of their own stock, both records, according to estimates compiled by TrimTabs Investment Research, a Santa Rosa, Calif.-based firm that tracks market trends for institutions.

Cash acquisitions are important because they take shares off the public market. Stock-swap-financed takeovers just replace one company's stock with that of another company.

Meanwhile, roughly $230 billion of new shares have been sold in initial and secondary public offerings and about $120 billion worth of stock has been sold by executives and other company insiders, TrimTabs estimates.

That means shares outstanding in the U.S. contracted by at least $600 billion this year -- roughly 3.1% of the market's total value, according to TrimTabs.

The U.S. equity market hasn't shrunk by that much in at least a decade. In 2005, the market contracted by roughly 2% and by less than 0.1% in 2004, TrimTabs estimates. From 1999 through 2003, the market expanded every year. (Percentages are based on the market capitalization of the U.S. equity market at the end of each year.) Players in the know

That trend is bullish because it shows that companies and their executives -- the players who know the most about future profits and other fundamentals -- remain optimistic, said Charles Biderman, chief executive of TrimTabs, likening the market to a casino.

"Typically, whenever the house is buying, the market goes up because they know more than you or I do," Biderman explained. "When they're selling, the market falls."

He cites 2000 as the perfect illustration. That year, retail investors poured mountains of cash into U.S. stock mutual funds, and yet the equity market cracked, beginning a bear market that lasted more than two years.

While individuals were piling into the market, insiders were selling and companies weren't as eager to repurchase their own stock.

There were almost $400 billion worth of new share offerings and $284 billion of insider selling in 2000. The U.S. stock market expanded that year by a record $254 billion, or 1.67%, according to TrimTabs.

This year, the opposite has occurred. Corporations have repurchased their own stock in record amounts, while U.S. equity mutual fund inflows remained sluggish as retail investors favored overseas funds.

From May through August, when the stock market was testing its 2006 lows, more than $20 billion flowed out of U.S. domestic equity funds, according to TrimTabs. As the Dow Jones Industrial Average climbed more than 2% in September, just $2 billion flowed into U.S. domestic equity funds.

Overall, U.S. investors pulled money out of equity mutual funds this year and poured into international equity funds, taxable bond funds and especially money market funds instead, despite a good year for equities, according to Prudential Equity Group.

However, that could change in 2007, partly because two strategists at brokerage firms with millions of retail clients recently eased off their cautious stance on the U.S. stock market, Ed Keon, Prudential's chief investment strategist, said in a recent report.

Keon expects the S&P 500 to close at 1,630 at the end of 2007. That's roughly 14% above the benchmark's current level.

Indeed, U.S. equity mutual fund flows have already begun to pick up in recent weeks. TrimTabs estimates that $5.8 billion flowed into these types of funds in the first half of December, surpassing November's $5 billion estimated inflow.

For Biderman, a big return of retail investors next year may signal a peak for the U.S. equity market. "When the dumb money starts buying heavily it's the end of the game," he said. "But right now it's still the smart money buying."

Another early sign of trouble would be if insider share buying and stock repurchases by companies slow, he added.

Recession

Other strategists questioned the link between a shrinking stock market and rising prices.

Vadim Zlotnikov, chief equity strategist at Sanford Bernstein, noted that during the last LBO boom in the late 1980's, the overall size of the stock market probably declined as lots of companies went private. But instead of sparking equity gains, a recession followed. "To draw too many conclusions from this is tricky," he said in an interview.

The current buyout boom has been fueled by several years of stability in stock-market fundamentals such as corporate profit margins, Zlotnikov explained.

Investors have begun to assume this stability will continue off into the future. Thus, companies that were once considered too cyclical are now thought to be more stable and suitable for acquisition or LBO, he argued.

"If stability persists, this trend will persist and push equity valuations higher," he said. "But the question is whether this stability remains."

Zlotnikov then rattled off a list of risks to stability, including an unexpected increase in interest rates, geopolitical turmoil roiling energy markets and a further deterioration of the U.S. mortgage market.

Indeed, TrimTabs' Biderman also worries that a jump in interest rates - by perhaps 1% percentage point -- would knock equity markets next year.

Wachovia's Smyth sums up his stock market outlook for 2007 as "the return of exuberance."

"I don't think it's irrational yet, but the second half of 2006 was the first time in several years that investors have put on rose-tinted glasses to look at the future," he said. "I can make a case that justifies a higher market in 2007, but everything has to go right," he added. "That means inflation subsiding, earnings growth decelerating but not falling and a nice, soft landing for the economy."

Alistair Barr is a reporter for MarketWatch in San Francisco.