A possible case of stock market over-reaction

The US economy; Myners lather; Bio-tech issues
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The Independent Online

The news on the American economy is not all bad. Yesterday's figures confirmed that manufacturing is still in recession, with a further fall in output last month. On the other hand, consumer confidence has revived this month, to the surprise of Wall Street's highly paid pundits.

The news on the American economy is not all bad. Yesterday's figures confirmed that manufacturing is still in recession, with a further fall in output last month. On the other hand, consumer confidence has revived this month, to the surprise of Wall Street's highly paid pundits.

The bears didn't like this small ray of sunshine in the gathering gloom one little bit, and to show their disgruntlement, they marked share prices lower again. One rational explanation for their reaction is that a revival of consumer confidence makes a three-quarter-point interest-rate cut by the Fed on Tuesday less likely than a mere half-point. Pure chagrin seems just as plausible an explanation.

Consumer confidence is what the outlook for the American economy this year hinges on. If it stabilises, the necessary rundown in business inventories and investment will be shallower and shorter than if confidence continues to plunge. Yet confidence in turn depends on the stock market. The link between share prices and business sentiment is pretty clear. Lower share prices mean a higher cost of capital, or sometimes no capital at all, so in a bear market companies tighten belts and rein in. Less clear is to what degree a roller-coaster Dow - or should that be helter-skelter? - undermines the consumers' willingness to spend.

The crash of 1987 hardly affected the economy, as it turned out, but a higher proportion of US households own shares now, and the correction to prices this time round has been a much slower process. Today, 30 per cent of US households hold shares directly, which is plainly a lot bigger than the 17 per cent which held them in 1987. However, some of this growth may be down to wealth enhancement more generally, or simply the possibility that proportionately more money is saved directly in the stock market these days than indirectly through mutual funds. In any case, there is no overwhelming evidence for the proposition that consumer spending is more dependent on the so-called wealth effects of rising or falling share prices than it ever was.

That does not mean the market turmoil doesn't matter, but like the foot-and-mouth outbreak, it should be kept in perspective. It is more than possible that the capital markets are over-reacting, and furthermore that the extent of this over-reaction will not be as damaging to the real economy as widely thought. As the upturn in consumer confidence suggests, the jury is still out on the likely severity of the US slowdown.

Even a half-point interest-rate cut on Tuesday, on top of the one percentage point reduction so far, will help. And, as Alan Greenspan hates to surprise the markets, the Fed might still opt for the bigger move.


Myners lather

Most of the Paul Myners report on institutional investment is uncontroversial, sensible enough stuff, but there was one recommendation which has sent the City into a right old lather - the proposal that fund managers are required to absorb the cost of commissions within their overall fee from the client. If implemented, the measure is likely to have far-reaching consequences, not all of them predictable or necessarily desirable.

The purpose of such a requirement would be to address the issue of "soft commissions", whereby some fund managers receive "free" services from securities firms in return for placing their clients' business with them. As Mr Myners points out, commissions are a very significant cost to pension funds, but although they are generally disclosed to the client, this is done in a way that is far from transparent. The cost of individual transactions is billed as you might expect, but rarely are their total cost aggregated so the client can see the big picture. The client also has no direct involvement in negotiating these fees and deciding where their business is placed, nor does he generally see what "free" services are supplied to the fund manager in return.

Perhaps oddly, "soft commissions" are a much bigger thing on Wall Street than they are in the City, but even so, most British fund management groups indulge in them to some degree. Such services are many and varied. At one extreme there's the familiar oil of free lunches, rugby tickets and shooting and golf days. Further up the scale, there are bigger-ticket items such as free Reuters and Bloomberg terminals. But the vast bulk comes in the form of "free" investment research.

A great deal of this research is of questionable quality and independence. The material is spewed out in ever increasing quantities, and although investment houses have been known to put sell recommendations on corporate clients, this is a rarity. Most circulars say buy, and like nearly all stock-picking, they are wrong at least as often as they are right. Many analysts are in any case directly employed for the purpose of bolstering the corporate finance function (valuation modelling for IPOs, takeovers and other transactions), and are therefore incapable of giving independent advice to investment clients.

Still, to dismiss all investment research as completely useless is too glib. Many quoted companies wouldn't get covered at all but for the activities of the house broker, and the sheer quantity of research on larger companies does make them beholden to the capital markets in a way they might not otherwise be.

A big reduction in the quantity of research, and a paucity of it altogether for some quoted companies, might therefore be one consequence of the Myners proposal. The law of intended consequences might apply itself in another way as well by accelerating the trend towards "netting" of commissions.

With a number of fund management groups, the big investment houses don't charge commissions at all on some transactions, but gross it into the overall cost of the shares. The client thus pays a slightly higher price than he might otherwise do. This only really works for securities houses with big market-making functions; for agency brokers it is much more difficult. So another effect of the Myners proposal might be a decline in the number of small and medium-sized brokerages.

There is an indisputable logic in what Mr Myners recommends, and as a fund manager himself, it was a quite brave thing to have done. But has he fully thought through the consequences? The Government naturally leapt at the chance to climb aboard the bandwagon. Here is a radical City reform which can be backed without seeming to be spiteful. Labour has searched long and hard for such measures, but until now without much success.

Melanie Johnson, Economic Secretary to the Treasury, gleefully announced the Government's full commitment to its implementation at the National Association of Pension Funds annual conference this week. She should not have been so hasty. Things aren't as black and white as they seem, and certainly this proposal will need more work and thought before being committed to statute.


Bio-tech issues

The capital markets are not entirely closed to new equity issues, it would seem. PPL Therapeutics yesterday announced proposals to raise £45m through an issue of shares, and Oxford Biomedica is raising £27m. In December, Oxford Glycosciences raised a thumping great £170m. Bio-tech share prices have suffered along with the techs, but even though bio-techs operate on much longer lead times than their digital peers, sentiment seems more disposed to them. The reason? The risk of product failure, the level of competition and the size of market are much easier to predict.