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economist.com
Stockmarkets in America and Europe
Stop this dream
Jul 18th 2002
From The Economist print edition
Might stockmarkets still have a lot further to fall?
CHEER up: a point will come when share-price falls on both sides of the Atlantic are no longer warranted by the calculation of future returns from those shares. And, all can agree, that point is now closer. For over a week until July 16th, American markets fell almost every day, and Europe followed or fell even more.
America's S&P 500 index has now shed 20% this year and 40% of its value since its peak in March 2000 (see chart). London's FTSE 100 index is also down by 40% from its peak in December 1999, retracing six years of gains. The FTSE Eurotop 300 index of continental European shares has fallen by 45%. Connoisseurs of manias, panics and crashes talk of a stage of capitulation in every bubble's bursting, when investors abandon hope that share prices will ever find a floor. With hairdressers and out-of-work actors now losing sleep—and calling their brokers in the morning—has the moment of capitulation come?
Not yet. Put aside for now the effect on share prices of what the chairman of the Federal Reserve, Alan Greenspan, this week called the “infectious greed” of executives and shareholders—a greed that has done much to knock confidence in the system of capitalism itself. Even without those doubts, share prices in America, though much less so in Europe, are still out of line with what the economy is likely to deliver in the coming years.
How far out depends on your assumptions about future economic growth and hence corporate profits, but even more on what method you choose for valuing shares. A growing band of analysts who think the market is bottoming out points to a tried old method, called the Fed model. It looks at the gap between the earnings yield (earnings per share divided by the share price) of the S&P 500 and the yield on ten-year Treasury bonds. Buy, the model screams. Compared with bond yields, American shares are at their cheapest since 1987, or since 1980 if forward-looking earnings are used.
Not so fast. The Fed model may have been a good predictor of value during the bull market of the 1980s and 1990s, but today's environment is suddenly different. Powerful deflationary forces arise when stockmarket and high-technology bubbles burst, and when there are savage cuts in inventories and company investment. If bond yields are falling because a deflationary trend has taken hold, that is no longer good for equities. Just look at Japan since 1990 and the rest of Asia after its financial crisis of 1997-98.
Deflation helps to explain why, for the first time since the 1930s, share prices have not responded to aggressive easing by the Federal Reserve, even though interest rates are at a 40-year low. Bonds and equities, says Christopher Wood of CLSA, a securities house, have decoupled. Bonds, not equities, are the best asset class in times of deflation—notably euro bonds, if the currency continues to rise above the parity it breached against the dollar this week.
What are better measures of share valuation, then? In America, the price/earnings (p/e) ratio—share prices divided by earnings per share—still assumes implausibly high growth in company earnings. The post-war average p/e for the S&P 500 is 15; now it is 40, implying a drop in share prices of three-fifths to return to the historical norm. Yes, but the ratio is high in part because earnings have been hit by all sorts of exceptional costs and write-offs. That is precisely the problem, retorts Martin Wolf in the Financial Times. These write-offs reflect earnings that companies exaggerated in the boom years. Who is to say that today's reported figures do not hide more nasty surprises, in the form of manipulated earnings, duff investments or outright fraud?
Investors, in other words, ought logically to demand a higher risk premium for holding equities, implying lower share prices. Dresdner Kleinwort Wasserstein does a back-of-the-envelope estimate. That firm supposes that investors now expect a very modest 7% annual return from American equities (four percentage points more—this is the equity-risk premium—than the return on Treasury bonds indexed against inflation). Such a risk premium implies that the S&P 500 may still need to fall by another 40-50%.
Here's another quaint notion, one that would have been laughed out of hand not long ago: judge shares by the dividend cheques companies write. If investors can no longer count on capital gains from their equity holdings, a steady flow of income, namely dividends, might well prove welcome. Again, the idea bodes ill for current share prices in America. The dividend yield on American shares averages 1.7%, though add in share buybacks, which increase returns to shareholders, and the figure rises to 2.3%. Assume a trend rate of growth for the American economy of, say, 3%. Then, very roughly, the expected long-term return on equities should be the two figures added together—that is, 5.3%. Since the return from index-linked Treasuries is just 3%, this implies a very small premium for the risk of holding equities of just 2.3%. Lower share prices are the conclusion.
There was a time when Europe could afford not to be particularly bothered by what happened in American markets: no longer. Between 1976 and 1999, correlations between American and European markets were low, ranging from 0.24 for Italy (0.0 represents no correlation and 1.0 represents lock-step movement) to 0.5 for Britain. Since late 2000 correlations have been as high as 0.9. Some correlation is justified by growing trade and investment linkages between America and Europe. Some, too, is explained by a similar trajectory in Europe of an asset-driven boom and bust. Still, it is hard to argue that European excesses were greater than America's, and certainly stockmarkets did not rise as high. Yet they have fallen by more.
The outcome is that, by most measures of valuation, share values in Europe are more justifiable than they are in America. In Britain, for instance, the equity-risk premium is reckoned to be at around its historical average. Certainly, p/e ratios there are back to their average; they are below average on the continent. In a look at implied volatility in the options market, Lehman Brothers says that continental share valuations are showing signs of distress akin to the time of the Russian crisis of 1998 and last September's attacks. It bets on a rally before long.
If the new era of tightened correlation allows it. In this bear market, jittery investors seem to have sold indiscriminately in favour of bonds with a cast-iron return. That leads to a final concern. Just as stockmarkets overshot on the way up, so they will overshoot on the way down. No big deal, you might think—a chance, even, for bold investors to make a killing. The danger comes when plunging stockmarkets swamp an emerging economic recovery. That has not happened yet. Yet the risks have risen over these turbulent weeks. |
