Financial Daily from THE HINDU group of publications
Monday, Nov 10, 2003
Columns - American Periscope
Running ahead of reality
V. Anantha Nageswaran
An experienced observer gave a rule of thumb calculation: The market capitalisation of the Stock Exchange of Thailand was roughly 3 trillion Thai baht. One US dollar exchanges for 39.8 Thai baht. About 60 per cent of it is considered free float. That is, around 1800 billion baht.Given 220 trading days in a year, the average daily volume of free-float stocks could be around 10 billion baht. The average trading volume has hit 60 billon baht recently. There is six times more trading than what could be expected based on the market capitalisation of free-float of stocks.
It is occurring due to churning of stocks by speculators. Stocks are not being bought or sold as investments but with the hope of finding the next buyer who does not want to be left behind in the frenzy.
Many point to the fact that the Thai stock market price-earning multiple is not that high and is, in fact, below the 10-year average multiple. Fundamentally, the Thai stock market might have potential over time.
However, the stock market could run ahead of improvements in reality and, when it crashes, it does jeopardise the realisation of good times, expectations of which drove the prices up in the first place.
Investors should instinctively decide that if something smells, tastes and feels like speculation, it is one, no matter how much of a defence one could mount based on so-called fundamental analysis.
A similar argument could, perhaps, be made for Indian stocks too. One is very pleased to see investors recognise India's potential. The Reserve Bank of India reckons that the economy could grow at a rate of 6.5-7 per cent in the fiscal year ending March 2004 and feels that there is an upside risk to its forecast.
The stock market rally is based on a broad group of stocks moving higher pharma, banks, industrials, technology stocks and other cyclicals. There are early signs of the emergence of the Indian multinational.
Tata Motors has concluded an agreement to buy into Daewoo Commercial, and Ranbaxy and Dr Reddy's continue to win approvals in America for the marketing of generic versions of drugs on patent expiry. Wall Street Journal, in a front-page story (November 4) on the Indian banking system, declares that it is one of the under-reported competitive advantages of India.
Despite India's many advantages and the reasonably high potential it has to deliver a real growth rate in excess of 6 per cent over many years, questions must be asked if the stock market has moved up too much too soon.
It is very important for the regulators not to be caught in a situation that reveals a scandal beneath the impressive market ascent in recent months. The government is planning to divest its residual stake in many companies that have already passed on to private hands.Corporations are planning new listings and retail investors are tiptoeing back into the equity market. Sustained vigour and health of the capital market is essential to maintain the present economic growth momentum.
The Securities and Exchange Board of India must remain vigilant and do whatever it can, to dampen speculation.
The Reserve Bank of India, in this regard, deserves to be commended for choosing not to add fuel to the fire by reducing the bank rate and the cash reserve ratio. Indeed, by lowering the inflation forecast and leaving the bank rate unchanged, it has engineered a quiet turnaround in the monetary policy towards a slightly more restrictive stance.
Investors, on their part, should realise that much of the favourable conditions that drove the impressive ascent of emerging equity markets have turned less favourable.
Back in March, in the immediate aftermath of the launch of the war on Iraq, the global risk appetite was quite low, central bankers in OECD countries had just begun to turn on their liquidity taps, there was uncertain outlook for growth in OECD countries and stock markets in the developing world were still relatively undervalued.
Stock markets in the developed world appeared poised for a turnaround based on improving liquidity and growth prospects thus imparting a positive feedback to the developing world.
Eight months later, risk aversion has turned to euphoria. Investors have, in fact, been ignoring geo-political risks. Standard and Poors has warned South Korea that the collapse of its neighbour to the North was a matter of time.
The quagmire in Iraq shows no signs of ending and the Israel-Palestine standoff continues, with Syria and Iran too being targeted now. The arrest of a prominent businessperson in Russia underscores the risks that lurk in former Communist countries.
Closer home, the Sri Lankan President has unfortunately chosen to throw a spanner into the peace process that deserved to continue, no matter how imperfect it was. As for OECD growth, the US economy appears to have turned the corner and the risk, if any, is that it runs out of steam faster than even the sceptics expect.
With consensus forecast of economists in the US and that of the Federal Reserve Board expecting an average 4 per cent growth in the next few quarters, the risk is clearly tilted to the downside.
There are some tentative signs that the average American household is beginning to tire of endless shopping.
Automobile sales in October were weaker than expected and so were chain store sales (chain stores are those that operate throughout the country and are open for more than a year).
Federal Reserve Senior Loan Officers' survey points out that demand for mortgage loans has begun to wane. On Japan, it suffices to say that there are conflicting opinions on whether the country maintained its growth rate of the second quarter in the third.
In any case, much of Japan's real growth is not real. It comes from deflation. Nominal GDP growth has hardly budged. In deflationary times, it is wrong to focus on real growth. It paints a false picture of economic health.
Emerging stock markets are no longer undervalued even if they are far from being overvalued. The valuation argument for emerging equities is now neutral as opposed to being strongly in their favour at the beginning of the year.
Valuations in the US have, for the most of the last three-year bear market, remained difficult to defend. Based on the forecast of $56 earnings per share next year, the Standard and Poors' 500 index sports a P/E multiple of around 19. While it appears reasonable, it is still well above the 70-year average P/E ratio of 15.5.
Further, forecasts of earnings growth in some of the technology sectors next year are well above the average earnings growth that the companies in those sectors delivered during the technology boom era of the 1990s (see Table).
Therefore, if the US stock market has discounted a lot of optimism on economic and corporate earnings growth, then any disappointment on either count would trigger a correction of significant proportions.
Then, emerging markets cannot escape the fallout for speculators who, rather than investors, are behind their recent sharp appreciation. Further, over the last several years, the correlation between emerging and developed countries' stock markets has been quite high.
The liberalisation of capital flows in Asia, Europe and in the US in the last decade has led to institutional investors operating simultaneously in many countries. Hence, when they react to shocks in any one region and turn risk-averse, they reduce their investments in other parts of the world. This triggers a synchronised correction in global equity markets, no matter how different their economic prospects are.
Last, the liquidity cycle has perhaps not much room to run and might even be getting reversed in a few countries. One of the first to sound the warning bell was the Reserve Bank of Australia. It raised its benchmark rate from a historical low of 4.75 per cent to 5.0 per cent on Wednesday.
Despite expecting the short-term inflation developments to be favourable, the central bank went ahead with a rate hike because it has grown quite concerned at the rampant credit growth in the economy and the near-vertical increase in house price charts in all the major cities.
The Bank of England, too, did likewise,raising its base rate from 3.5 per cent to 3.75 per cent on Thursday. In both these economies, the bubble in home prices is arguably far bigger than it is in the United States.
Thus, there is less working in favour of global equities and emerging market equities, in particular, now than about eight months ago.
Hence, much as one recognises their long-term superior growth potential, there is nothing inherently contradictory in acknowledging that, in the short-term, markets might have raced well ahead of macro-economic improvements.
If China and India maintain their high growth rates for the next decade and more, and if Japan finally emerges out of its economic funk, then Asia would become the global economic centre of gravity. Its stock markets need not be slave to developments in the US economy or in the American stock market. However, that is work in process.
The ability of Asian stocks to decouple from a correction in the US markets is yet to be fully tested. Hence, for now, investors would do well to emulate the stance of the legendary American investor, Warren Buffett.
In his Berkshire Hathaway Fund, he is sitting on $24 billion of cash because he does not find anything of value in either stocks or bonds. Such a disciplined approach is an essential component of successful investing.
(The author is Director, Global Economics and Asset Allocation in Credit Suisse, Singapore. His views are personal. Please address feedback to firstname.lastname@example.org)
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