Prices or earnings? Only one matters

SCMP April 20

Is the world dangerously obsessed with stock prices as a measure of prosperity and sentiment?

In posing the question, I am not referring to the harmless daily habit of following the prices of one's own investments in the same way as the football scores. Nor even am I thinking of the "buy, buy buy" hype that characterizes the markets coverage offered by the business TV channels.

What is genuinely worrying is that the obsession seems to have reached those people who ought to least impressed by the ups and downs of stock prices, the guardians of sound money, the central bankers.

Hongkong set a poor example with its massive intervention in 1998, presented, not entirely honestly, as a defence of the currency peg. The buying spree looked clever enough at the time. Without it the Hang Seng index might well have fallen to 5,000. But the subsequent unwinding of this purchase of 10% of the Hang Seng index has been one reason why Hongkong's economic recovery, as well as its stock index, has lagged the rest of Asia. Meanwhile it cushioned Hongkong from the kind of shock needed to generate change. Hongkong now looks more like a static Japan than a reviving Korea.

The latest official - and stockmarket hope - is that mainland money will come to rescue as Hongkong is given the benefit of China's first steps to liberalize portfolio capital outflow via qualified institutions. Hongkong should be discouraging this. Firstly it should, if it wants to maintain its international status, never consciously seek special privileges from the mainland. Equally it should never suggest to the still mostly impoverished mainland that it has any obligation to give Hongkong any breaks.

Such a move is also likely to be contrary to the interests of most mainlanders. They are likely to be more interested in H shares than in traditional Hongkong counters, property and banks. Yet only a few privileged institutions will have access to the relatively cheap H shares. Most Chinese will continue to have to have access only to much more expensive A shares of the same companies. Existing H shares holders - myself included - will likely profit yet again at the expense of mainland counterparts. Gradual liberalization of capital outflow is a good idea but giving a special privilege to Hongkong is bad for both. It looks like another short-sighted prop to Hongkong.

Returning to the issue of central banks and stock prices, HK Monetary Authority boss Joseph Yam can now claim that he is not alone in using stock intervention as a new tool of central bankers. Nor is he just in the company of authorities such as those in Taipei which have often and blatantly intervened in the market for political purposes. No. The alarming indications that central bankers should concern themselves with stock prices has come from the west's own leading central bankers.

It has come to light that the US Federal Reserve recently considered the use of "unconventional" measures to boost confidence and the stockmarket in the event that last year's dramatic cuts in interest rates failed to have the desired result. Those prospective measures undoubtedly included intervention in the stockmarket. Indeed it remains possible that the Fed did indirectly intervene through the derivatives markets.

If that possibility is unsettling enough, even more remarkable was the suggestion from none other than the president of Germany's Bundesbank that it might sell some gold and re-invest in a portfolio of European equities. To cap it all, the European Central Bank head Wim Duisenberg suggested that there was nothing "unusual" about central banks buying equities. So from the conservative heart of Europe, land of cautious money growth and tight restraints on inflation and fiscal deficits, comes apparent support for yet more moral hazard.

There are several things which are highly objectionable about this proposition. In the first place, central banks are not investment funds. Their assets are there to influence interest rates and the exchange rate, to ensure stable and appropriate monetary growth. Gold is a monetary asset not a normal commodity or earning investment. (The Hongkong government could make a case for investing some of its fiscal reserves in equities but only if it divorces its fiscal reserves management from monetary management and exchange rate defence).

Secondly, the inclination of the central banks is clearly always to intervene to prevent prices falling. Have they ever been known to intervene directly to deflate bubbles? Intervention is inevitably asymmetric. Anyway, who are they to determine the correct level of specific asset prices?

The central bankers have plenty of monetary instruments to regulate the growth of credit, and tools such as margin requirements to influence lending to specific sectors such as stocks and housing. They should stick to these. The argument that falling stock prices is bad for consumer confidence may be half true. But it exhibits the sort of short term thinking that central bankers are supposed to avoid and which has made profit manipulation so widespread.

That was exhibited in extreme form by Enron and Arthur Andersen but even companies as illustrious as IBM have engaged in dubious accounting to inflate profits and beat "analysts' estimates". What matters to us all as investors is not current stock price levels but the real returns on capital both now and in the future.

Recent evidence suggests that official desire to prop up share prices has kept them at levels which are well above reasonable, and historical, long term earnings and inflation expectations. This is doubly dangerous as many pension plans in aging societies have come to depend on assumed capital growth rather than earnings.

The real (after allowing for inflation) earnings yield on the S&P index is currently negative and the prospect for earnings outpacing nominal GNP growth in the next few years is poor. Use of central banks tools to prop up asset prices while earnings decline may improve the images of Messrs Greenspan and Duisenberg but is creating enormous future problems, especially for countries with fast aging populations.

What we need is low asset prices and good returns. Now most markets in the developed world offer the opposite. Financial asset price inflation as now deemed good by Greenspan & Co represents a transfer of wealth. In Hongkong that enabled Richard Li and insiders who got early into the PCCW ramp to make huge profits at the expense of come-later small shareholders. Valuation was divorced from recurrent income generating capacity.

Brokers and investment bankers love high asset prices. The rest of us should beware.


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