Dow Jones: A Fairy Tale Ending?
by Phillip Cogan
Next stop, 10,000? The Dow Jones Industrial Average seems on course for that benchmark. At one point yesterday it was just a few dozen points short. At the same time, its British cousin, the FTSE 100 index, was setting new highs. The problems that dogged world markets last autumn seem to be fading from the memory.
On the surface, the key to the revival is that Goldilocks is alive and prospering, albeit to different degrees, on both sides of the Atlantic. A Goldilocks economy, like the fairy tale heroine's porridge, is one that is not too hot to cause inflation, nor too cold to cause recession, but just right.
In the US, sure enough, economic growth marches briskly on without any sign of inflationary pressure. In the UK, the porridge might be tepid, but at least recession now looks less and less likely. It seems that Britain is avoiding the worst of its old boom-and-bust cycle.
But the economic news tells only part of the story. Underpinning the remarkable resilience of the US and UK equity markets has been the most obvious form of support for any commodity, from aluminium to zero-coupon bonds: a shift in the balance of supply and demand.
More money is pouring into equities, thanks to low returns on alternative investments (such as cash or bonds). But because companies are buying their shares back, or not issuing new ones, the supply of equity is shrinking in the US and the UK. With demand rising and supply falling, it is no wonder prices are up. As they used to say of land, it seems they aren't making equities any more.
A figure like 10,000 on the Dow is, of course, just a number. But the imminent reaching of that landmark inevitably raises the questions: how much longer can this last? How imminent are the threats that might bring it to an end?
Back in the autumn, of course, it seemed as if the bull market was already over when Russia's default, the continuing crisis in Asia and the near-collapse of US hedge fund Long Term Capital Management appeared to threaten a global recession. Investors then fled equities for the safe haven of US bonds: the S&P 500 index dropped nearly 20 per cent, the Footsie 25 per cent and European markets 35 per cent in less than three months.
Fortunately for stock markets, central banks rode to the rescue, with the US Federal Reserve cutting rates three times, the Bank of England five times, and even the euro bloc managing a collective rate reduction before the introduction of the single currency in January.
Global growth is still not expected to be sparkling in 1999 and there are plenty of problem spots, such as Japan, Germany and Brazil. But the worst may be over for Asia, notably in South Korea; outside Germany, Europe seems on course for respectable growth; and above all, the US economy keeps charging forward. Economic growth was an annualised 6.1 per cent in the fourth quarter of 1998, but as Alan Greenspan, the Fed chairman, said on Tuesday: "There have been no obvious signs of emerging inflation pressures."
The UK economy is enjoying nothing like the same kind of growth as the US. Even on the UK chancellor's forecasts, which many analysts feel are optimistic, UK GDP is expected to grow by only between 1 and 1.5 per cent this year. But expectations of recession, widespread in the autumn, have started to fade as survey data have indicated an upturn in business sentiment.
All this has reassured those who feared that corporate profits were about to be severely squeezed. According to IBES, the information company, US corporate earnings forecasts have been rising steadily since December.
And the corporate sector is playing a big part in fuelling the rise in share prices. At this stage of previous bull markets, notably in 1987, companies were falling over themselves to issue new equity to take advantage of high share prices. But not this time.
In the four quarters to the end of September, there was net retirement of some $158bn of equity in the US, while in the UK the supply of equity was reduced by more than £30bn in 1998.
Two factors have been behind this shift: takeovers and share buy-backs. Takeovers or mergers offer companies two advantages. At a time when low inflation and moderate economic growth make it hard to increase sales rapidly, mergers enable companies both to cut costs, which improves margins, and to achieve the scale needed to become a price-setter rather than a price-taker in their sectors. As investors have recognised this trend, blue chip shares have outperformed small companies - increasing the incentive for companies to grow bigger by acquisition.
Share buy-backs have had an even greater influence than takeovers. There seems to have been a revolution in corporate finance, with managers accepting that surplus cash should not be hoarded but returned to shareholders. With cash paying a low return and debt tax-deductible, buy-backs also enhance earnings per share and reduce a company's cost per capital.
The result is that buy-backs normally drive share prices higher, something that manag ers, increasingly motivated by share options, have not failed to notice. They have happily borrowed money to buy back their companies' shares in the US; over the four quarters to September, the corporate sector accumulated some $359bn of debt, the highest ever 12-month figure.
Of course, higher gearing increases risk, but why should managers care? They get generous severance packages when they quit or are fired. And if share prices fall, boards are normally willing to rewrite options schemes to compensate.
There are some clouds on the horizon. Arguably the latest rally in US share prices in particular is showing even greater signs of being a bubble than before.
The long bull market in equities, which began in 1982, has been accompanied by a similarly profitable era for bonds, which has seen yields fall to levels not known for a generation.
Falling bond yields reduce both the borrowing costs of corporations and the temptation for equity investors to switch out of the stock market in search of a higher income. But they also increase the theoretical valuation of equities. The value of shares is the future dividend, or earnings streams, discounted to the present day; as the discount rate (normally the prevailing bond yield) falls, then the present value of those future earnings increases.
Since 1982, the value of US equities has increased more than ninefold. Only a third of this has been due to a rise in corporate profits; the other two-thirds has come from an increase in the multiple, the price-earnings ratio, which investors have been willing to attach to those profits. The rise in that ratio has been closely correlated with the fall in bond yields; without it, on measures such as dividend yield or price-to-asset value, shares would look horrifically exposed.
But the strength of the US economy has unsettled the Treasury bond market, with investors fearing either that inflationary pressures will return or that the Federal Reserve will raise interest rates to head them off. The yield on the 30-year issue, which dipped to 4.7 per cent in October, has risen to around 5.55 per cent, undermining the valuation case for shares.
The Fed keeps track of the relative valuation of shares by comparing the forward price-earnings ratio on the S&P 500 index with the 10-year Treasury bond yield. By last week, this showed equities looking 27 per cent over-valued. Such extremes of overvaluation had been seen only twice before: worryingly, that was in August and September 1987.
The UK stock market looks less exposed as both price-earnings ratios and bond yields are lower than they are in the US. But as has been shown so many times in the past, London will not be able to escape a setback on Wall Street - and nor will anyone else. A substantial fall in US equities would dent US and world growth.
What could bring a halt to the bull run? The most likely cause would be a realisation by investors that Goldilocks is starting to show her age. There are two opposite dangers, which cannot simultaneously be justified.
Some fear inflation. Part of the reason why inflation has been so low for so long has been the weakness of commodity prices, but the oil price has started to perk up in recent weeks. Without the support of falling oil prices, Lombard Street Research thinks US inflation could reach 4 per cent by the end of next year.
But the bigger fear is deflation, that the debt accumulated by governments, corporations and individuals over the past 20 years will prove to be an intolerable burden in a slowing economy. At some point, defaults will rise, creditors will start to demand their money back and the economy will suffer a credit crunch.
Optimists hope that the two forces will counteract one another and that neither threat will materialise. But the stakes are high. The UK and European economies are dependent on the US to keep world growth moving ahead, and the US economy itself requires a rising stock market to keep consumer expenditure growing. Just getting to 10,000 on the Dow may not be enough.
The Financial Times, March 13, 1999 |
