Back to basics for the market value pundits
People are relying on borrowing or a rise in their asset values to sustain demand
Tuesday 29 September 1998
We are not through the woods yet by any means, so expect a series of disturbing announcements from financial institutions about losses they have sustained.
Losses will stem not just from banks' loans to Long-Term Capital Management, but from the fact other banks were pursuing similar investment policies themselves. That is certainly what the plunge in bank share prices would lead us to expect.
It is impossible to say, but there may need to be rescues. However unless there is something truly dreadful still hidden, we should be prepared now for the focus of concern to change.
Expect two new developments: First, people will ponder why the US authorities had allowed the financial system to become so fragile. We all knew the Japanese banking system was fragile, but the American?
Secondly, they will become increasingly concerned about the way in which financial instability feeds back into the real economy.
On the first, there is not much that can be added at this stage. You cannot assess sensibly the regulatory failure until you know the full extent of the damage, and we won't for several months.
The second - the link between markets and the US economy - will become a live issue very fast. The US consumer has been the main engine of world growth through the last 12 months, even more than Europe, for continental European growth has been largely driven by exports, not home consumption.
Further, we cannot assume that continental Europe's recovery will be sustained. It will have to adapt to meet the demand of the one-size-fits- all monetary policy, which will be imposed by the new European Central Bank in three months. It would be surprising if the policy tended toward the looser end of the possible range.
So US consumers are very important. This week sees new information about the health of the economy in the shape of consumer confidence, the US purchasing managers survey, and unemployment. These are expected to be weak, though not in any dramatic way.
A fall in demand would be really troubling because consumers feel poorer as a result of the decline in the stock market.
PDFM have highlighted the link between share prices and demand. Bill Martin, the chief economist, points out that the private sector's cash flow has gone negative for the first time since the early 1950s. In other words, people are relying on borrowing, or the rise in value of their assets, to sustain demand.
What happens if share prices fall? Well, the possible impact is shown in the chart: a dip of about 5 per cent in GDP from where it would have been otherwise, with the trough about 18 months from the time of the collapse.
Interestingly it doesn't seem to make an enormous amount of difference whether monetary policy leans against the fall in prices, or ignores it. As the graph shows, in the face of a sharp market decline monetary policy is pretty marginal.
This is simply a computer prediction, and like all models, what comes out depends on what you put in. But clearly, if consumers have been relying on their accounts with investment banks to fund their spending, any fall in the market will have an immediate impact on this reliance.
Is a halving of US share prices realistic? Of course, no one can know. It is interesting, though, to note that the shares of some stocks have indeed halved in the few short weeks since the peak in July. By and large it has been the second-division stocks that have fallen most, so the big- share indexes like the Dow (or for that matter the Footsie) have been less affected. But there is no law that holds that the shares of large companies cannot halve. That happened to the shares of Barclays Bank, a perfectly sound business, but one which has suddenly become rather unfashionable.
PDFM have made themselves unpopular by being among the most bearish on the US market. For a long time, they were declaring it over-valued and every rise made them look more exposed. They were too early, of course, but now they are in the sun - the people who saw through the hype and correctly forecast the present decline. They believe there is lot more disappointment to come.
The difficulty is that really we do not know what measures to use, for you can construct measures which show that shares are still cheap - this applies both to London and to Wall Street. Thus if you look at the ratio between the yield on long-term bonds and the dividend yield of equities, you can claim that shares are still quite cheap. Bond yields have fallen so much that they have underpinned the decline in equity yields.
If, on the other hand, you use a price/earnings ratio, then shares are desperately expensive. At the peak, the UK p/e was about 22, at the very top end of its long-term range, and the dividend yield was 2.9 per cent, at the bottom of its range. The US figures were 29 and 1.5 per cent, both of which felt extraordinarily high. PDFM said so loudly at the time.
The tough question now is whether the subsequent declines of about 20 per cent bring these values sufficiently into line.
My own view is that they don't, and that we are entering into a period where investment managers will go back to basics: fundamental, long-term analysis of cyclical trends.
Take a view that this is one business cycle just like all the others and both shares and the world economy have some way to fall.
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