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Inflows distort pricing of risk Back  
Speaking at an AIB investment managers seminar recently, Joe Rooney, managing director of Lehman Brothers Global Equity Strategy, emphasised that the current long-running equity cycle was reaching a turning point. Rooney described how the New Economy, as it applies to the global equity market, is looking distinctly tired. The following is an extract from his presentation.
The fundamental factors which drive the global equity allocations have been on a deteriorating trend for the past few years. At the same time, all technical indicators which we use to gauge market psychology signal that investors have fully discounted the arrival of the New Economy. The fundamentals underpinning global equities have been degenerating, the level of speculative interest in equities rose to its recent crescendo. Collectively these fundamental and technical factors point to an equity market correction of at least 15 per cent. Indeed Lehman Brother’s sense is that events of the first half of the year 2000 will come to be seen as a turning point in the secular fortunes of this long equity cycle.

From an investment perspective, the New Economy played itself out through the 1992-1998 period and its beneficial impact was at its greatest in years into 1997. This period was characterised by a significant improvement in the profitability of the corporate sector as it applies to the investor. The return on the capital employed in excess of the corporate sector’s weighted average cost of capital rose continuously from the trough of the last recession through to 1998.

Over the past few years two things have begun to weigh in profitability.
• The cost of capital, particularly the cost of debt capital to the US corporate sector, is on a rising trend and (not unrelated)
• the corporate sector is having to commit ever increasing amounts of capital to its businesses in order to compete in the New Economy.

The decline in profitability is not related to the increase in the cost of capital but to the inability to estimate long term earnings growth rate for the corporate sector.

Sign of stress
Signs of stress in the corporate sector are very much in evidence in the way in which the US credit market is behaving. Already the spread between Baa and Aaa credits has widened to over 130 basis points - a level last seen when the recession and the Savings & Loans crises weighed heavily on the corporate sector.

Equally, we can find signs of stress in the equity market, not in the level of equity markets but in the volatility of equity returns. From its trough in 1996-97 the volatility of stocks relative to the volatility of bonds has been on a sharp inclining trend to the point where trend relative volatility now stands at levels consistent with recession.

Speculative excesses
What explains the recent failure to predict the forward movement in equities relative to debt? It cannot be explained away by the emergence of the technology and telecom sectors as secular growth sectors, for the market outside of these two sectors is overvalued. We attribute the breakdown in the relationship between value and subsequent returns to the emergence of speculative excesses.

The demand for technology and telecoms stocks has been such as to distort the traditional pricing of risk within global equity markets. In the past in was typical for some 40 per cent of all retail flows into domestic equities and bond funds to be directed at growth-oriented stocks.

By the end of last year the appetite for growth stocks was such that it could only be funded by the sale of non-growth-oriented equity funds and bond funds. By January 2000, the flow into domestic growth funds had reached nearly 350 per cent of inflows into total domestic equity and bond funds.

Startling inflows
If we add to the above figure the monthly uptake margin debt then in the US alone the flows into growth stocks for the first quarter of the current year ran at an annualised US$750bn or some 11 per cent of disposable income. And these figures ignore the flow into overseas equity funds. It is our view that these startling figures have distorted the pricing of risk in global equity markets.

To test that there is not a permanent disconnect between the equity and credit markets we looked at the same equity to risk relationship for the same stocks, based on data for the previous three years. It would appear that the scale of retail flows into equities in general and into technology and telecom stocks in particular has been enough to distort equity valuations and specifically those of the so-called New Economy stocks.

It is expected that the end of a long bull market in equities should be signaled by a rise in speculative activity. Yet this speculative activity has pushed equity valuations to levels which in our view are increasingly at odds with the deterioration in the market fundamentals. The process of adjustment is under way but it has further to go.

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