The Grisly Consequences of the Bear Market
How will it unfold?
The worst may never happen. Having fallen heavily in the wake of the Asian and Russian crises, global stock markets may quickly rebound and history will look back on the past few weeks as an unpleasant but necessary correction.
Severe bear markets - ones that have a significant impact on the real economy - have thankfully occurred very rarely this century. Yet, given that most western markets have fallen by a fifth in little more than a month and considering that 40 per cent of the world economy is either in recession or heading that way, it makes sense to ask: if the world is entering a new bear phase, what might be the consequences?
History is not much help. The two worst bear markets of the century - 1929-32 and 1973-74 - had significantly different causes. The former was associated with a credit crunch and deflationary pressures; the latter with inflation, linked to the oil crisis. Any late 1990s bear market would be different again, although its causes are likely to be deflationary, and therefore closer to the 1929 than the 1973 edition. However, it is possible to project a few significant themes.
* Private investors would become disillusioned. The US investor has fallen heavily for the "cult of equity": 39 per cent of US personal sector net wealth is held in the form of shares. European investors are well behind the US but have been catching up during the past year or so.
During the long bull market, falls in share prices have been seen as opportunities to "buy on the dips". But if there were a bear market, in which each rally is followed by another sell-off, the decline in investor morale would become self-sustaining. Instead of hanging on for long-term profits, investors would start baling out before more of their money disappears.
The crash of 1929 soured private investors' attitude to equities for a generation; after the mid-1970s bear market, disillusioned savers caused mutual funds to lose a third of their assets between 1978 and 1982.
There would be a "wealth effect", particularly in the US. American consumers have been spending money, confident that their mutual fund holdings were rising in value; if the market falls substantially, they are likely to cut back on spending and build up their cash holdings. Economic growth would fall as a consequence, perhaps by as much as 1 percentage point of gross domestic product a year.
Those who rely on personal, rather than occupational, pensions could then find that their pension is much smaller than they had expected. And if bond yields continue to drop, some would face a double whammy. Not only would the value of their accumulated fund have dropped, but the annuity they buy with their fund would also offer a lower return (because annuity rates are linked to bond yields).
And that would mean that the recent drive by governments to persuade current workers to finance their own pensions, rather than rely on the state, could peter out, which would blow a hole in long-term government finances. Talk of investing the US social security fund in the stock market, or of privatising the system so that beneficiaries can invest their own money, would be dropped.
* Government finances would take further blows. Those countries planning substantial privatisation programmes would either have to drop the idea or drastically reduce their revenue expectations.
Risk-averse investors would shut emerging markets out of the international capital markets for much longer than seems likely even now, after the effective Russian default and the International Monetary Fund rescue packages in south-east Asia. That would force developing countries to rely on their domestic markets, pushing up interest rates and reducing their economic growth. Those western companies that have pinned their long-term hopes on growth in emerging markets would have to rethink.
* Investment portfolios would be rearranged. If the "cult of equity" declined, bonds would make a comeback, increasing their share of institutional portfolios - especially if the bear market were caused by global deflation. The gradual shift by European funds out of bonds and into equities would be halted. But risk-averse investors would be interested in the debt only of developed nations and blue-chip companies.
The methods for comparing bond and equity valuations would have to be re-assessed. The inflationary 1970s and 1980s meant that, to attract investors, bonds had to offer a substantial yield premium compared with equities. This has come to be accepted as the norm. But before 1959, things were the other way around: equities had to yield more than bonds because of their riskier nature. If a bear market began, the premium might well revert to this traditional pattern.
* Corporate finance and new issue activity would slow down. After the crash of 1987, the amount of money raised in UK new issues fell by 25 per cent in the following year. The value of mergers and acquisitions activity in the UK fell from œ1.3bn in 1973 to œ508m in 1974 and just œ291m in 1975, according to Datastream.
A plunge in corporate finance activity would hit the profits of investment banks, just at the time when they would be suffering from the losses incurred by their trading arms in the face of falling share prices. Weakened firms would be forced into the hands of stronger rivals; some commercial banks would decide to withdraw from the securities business altogether.
Some firms would go under, as UK small commercial banks and financial conglomerates did in the bear market of 1973-74. In some cases, this would be caused by the combination of falling prices and leverage; in other cases, it would be due to fraud. For companies, the folk wisdom is that "recessions discover what auditors do not"; for banks, the same adage applies to bear markets.
The result would probably be calls for greater regulation of the markets. In the US, the 1929-32 era was followed by the Glass-Steagall Act, which separated commercial and investment banking; the 1987 crash by restrictions on trading strategies based on arbitrage between the cash market and the future. Derivatives markets, which outsiders (and even bank executives) find difficult to understand, would be a likely target.
* Jobs in financial services would be lost. Within weeks of the 1987 crash, US houses such as LF Rothschild and Kidder Peabody were laying off staff; it is estimated that about 20,000 jobs were lost in the City of London during the following year. Even where jobs are retained, bonuses would be cut. Property prices in the smarter areas of London and New York would slip.
* Share option schemes may lose their potency as a method of rewarding corporate executives. Executives have made fortunes from such schemes in recent years, particularly in the US. According to William Mercer, an employee benefit consultancy, last year chief executives at 138 out of 350 large US corporations had stock options with a face value of more than three times their pay and bonus.
But given the strength of the bull market, this may have had little to do with their management ability. As master investor Warren Buffett put it, it is rather like a duck in a rainstorm believing that its paddling efforts were causing the level of the river to rise.
Some companies would try to rewrite their schemes to adjust for lower share prices. In a drawn-out bear market, even this strategy (which outside shareholders are unlikely to welcome) would not work. Companies may have to start shelling out real money to keep their key executives.
This year, Smithers & Co, a London research group, estimated that US profits had been overstated by as much as one-third in 1995 and 1996 because of options schemes. Smithers argued that stock options were effectively part of employees' remuneration, and thus the costs of providing them should be charged to profits.
* Corporate profitability in general would be squeezed. The effective cost of equity capital would rise; weaker credits would have to pay higher yields on debt because of banks' aversion to risk; and those companies that have had pension contribution holidays would have to resume payments into their schemes. Weaker rivals would cut prices in order to get business, lowering margins across the board.
Finally, some securities analyst, somewhere, would claim to have predicted it all. They would be fˆted in public and their opinions would move markets for a while. Until, that is, their next big market call turns out to be wrong.
The Financial Times, September 5, 1998 |
