May 21st 2009
The feedback loops that sustained the bull market can work in reverse to devastating effect
BULL markets are about more than just rising prices. They create their own momentum, not to mention their own intellectual rationale (remember the “new era” talk of the late 1990s). When bull markets stop, those effects tend very quickly to go into reverse. The greater the excesses of the boom, the longer and deeper the reaction is likely to be.
The best known of these feedback loops is the use of borrowed money to buy assets. Rising prices make banks more willing to lend, creating more demand for the assets in question, pushing up prices even further and thereby appearing to ratify the original lending decisions of the banks. When markets fall this leverage works the other way, as could be seen when investors offloaded assets at fire-sale prices last year.
There are many other positive-feedback processes. Take share buy-backs, for instance. Companies used their cash (or borrowed money) to reduce their share capital. Markets might have treated this as evidence of a lack of imagination, or a paucity of profitable projects. Instead, they saw it as evidence that the managers were focusing on “shareholder value” and boosting earnings per share, however ephemeral that might have been.
By shrinking the supply of shares in the market, the buy-back splurge played its own part in prolonging the bull market. In America, Smithers & Co, a consultancy, says that net corporate buying of shares peaked at an annualised rate of around $1 trillion in late 2007. Companies were buying far more of their own shares than anyone else did. But the buying spree was unsustainable. Smithers calculates that American-owned companies were paying out some 70% of their profits at the peak, if you include dividends and buy-backs. They have since slashed dividends and will have to start issuing shares as well. Instead of borrowing money to pay back shareholders, companies now need to raise equity to pay back creditors.
The shift in the supply-demand balance is not confined to America. European companies have already raised a total of EURO56 billion ($76 billion) in rights issues this year, according to dealReporter, an information service. Robert Buckland, a strategist at Citigroup, says that British equity supply was shrinking at 4% per annum in early 2008, and is now growing by a similar amount. That is all down to financial companies, which have had to raise capital to repair their balance-sheets; net issuance from the rest of the market is basically flat.
The recent stockmarket rally has undoubtedly helped companies successfully issue shares. But it will also tempt more businesses to sell equities, putting a potential cap on the rally. As Mr Buckland puts it: “Equity issuance soaks up money that might otherwise have been used to drive the market higher.”
Another positive-feedback loop in bull markets used to be the final-salary pension fund. As share prices rose, pension schemes would move into surplus, allowing sponsoring companies to enjoy contribution holidays. That boosted both their cashflow and their profits, giving a further uplift to share prices. American companies could include an “expected return” from pension assets in their income statements, a return that drifted higher over the life of the bull market.
But a dismal decade for equities and low bond yields have now sent many companies into deficit. In Britain, under the fairly conservative assumptions used by the Pension Protection Fund, private-sector schemes had a deficit of GBP188 billion ($277 billion) in April. Having an exposure to a final-salary pension scheme is now a drag on a company’s share price, not a boon. BT, for example, is almost having to double its annual pensions contribution to GBP525m, a move that helped prompt a 59% decline in the British telecoms giant’s annual dividend.
Tax and regulation also work in a buoyant market’s favour. Booms tend to bolster tax revenues and make the government appreciate the virtues of the finance industry; cities compete to attract banks and asset managers by offering tax advantages and minimal regulation. When the bust comes, taxes rise and regulations are tightened. Activity slows and investment is discouraged.
All these effects can take many years to gain momentum, and help explain why bull markets can last much longer than observers expect. By the same token, however, when these processes go into reverse, they can also be self-perpetuating. And that is why there will have to be a lot more evidence than a couple of months of rising share prices before one can say that a new bull market is under way.
AN ARTICLE FOR YOU, FROM ECONOMIST.COM –