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Weak economics, strong equities

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While economic growth and corporate earnings disappoint, stock prices have recorded strong gains.

In 2012, the MSCI All-Country World Index of equities increased 16.9 per cent in 2012 including dividends. The U.S. S&P 500 Index increased 13 per cent, the most since 2009. While the German economy slowed, recording only marginal growth, the DAX rose 29 per cent. The French economy performed even worse but the CAC40 rose 15 per cent. Despite the fact Italy faced serious economic problems, the stock market rose eight per cent. While Spain tottered on the edge of needing a bailout, stocks fell a modest five per cent.

The phenomenon extended to emerging markets. While India's economy stagnated, the Sensex Index increased 26 per cent. The South Korean and Brazilian stock markets both rose despite rapidly slowing growth. Argentina's stock market grew 17 per cent despite its dysfunctional economy.

Changes in the economic environment have altered the dynamics of stock markets. Macro-economic factors, slowing growth and especially policy measures such the global regime of zero-interest rates and quantitative easing, colour most markets, driving the valuation and performance of firms.

Profit margins and cash flows improve, perversely, in a period of low growth. Initially, companies cut costs, improving profitability. As revenues are stagnant, companies have no need to invest in expanding capacity or working capital, releasing cash flow. Reduction in depreciation charges and the ability to use cash flow to reduce debt reduces interest expenses. In the present cycle, sharp decreases in interest rates, though not necessarily interest margins, have also improved profit margins. Cost-cutting, productivity improvements and restructuring cannot be repeated endlessly.

In the long run, increases in profitability require revenue growth. But lower growth translates into lower demand, slowing revenue increases. Lower demand and also over-capacity in many industries have reduced corporate pricing power, decreasing profitability.

A striking feature of recent corporate history has been low- and poor-quality revenue growth. Earnings have increased more than revenues. Where companies or sectors experience revenue growth, the causes are interesting.

Beneficiaries of government spending targeted at increasing demand have benefited. Artificially low interest costs have encouraged substitution of technology and mechanized equipment for human resources, boosting revenues of technology and industrial-equipment manufacturers. Commodity producers' revenues have benefited from rises in volumes (driven by emerging-market demand) and higher prices. Some firms have increased revenue by cannibalizing competitors and adjacent industries.

The buildup of cash on corporate balance sheets is frequently cited as a sign of corporate health. In the U.S., since 2008, companies have been net lenders rather than borrowers and now hold around US$1 trillion in cash. Japanese companies hold liquid assets of US$2.8 trillion. European companies also hold large cash balances. Mark Carney, the newly appointed Bank of England governor, referred to the $300 billion of cash held by companies in his native Canada as "dead money."

The high cash balances reflect uncertainty about future financing conditions and the willingness of banks to lend. But it primarily reflects the lack of investment opportunities.

Cash surpluses affect stock prices and returns. Many companies have returned capital through stock buybacks and higher or special dividends. In the U.S., fear of tax changes has also been a factor. But investors are now faced with the problem of where to deploy the cash.

Other companies have used surplus cash to purchase competitors, businesses or assets. Given the indifferent results of many mergers and acquisitions, it is unclear that this will benefit anyone other than shareholders of the acquired company and investment bankers.

Equity valuations increasingly also reflect changes in the market environment.

Changing demographics affect stocks. Investors approaching retirement may switch to more defensive assets and seek steady income, favouring bonds and cash. Low and declining returns over time have also undermined demand for equities. The reduction is evident in outflows from equity funds into other assets.

Low interest rates have driven stock prices. Dividend-paying stocks have benefited from the attention of investors seeking income. Algorithmic trading now dominates stock markets, making up between 30 per cent and 70 per cent of all activity. Computerized trading may increase volatility. Revelations of insider trading also undermine investment interest, especially from retail investors.

These changes make valuations based on history more difficult.

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money.

Republished from the Winnipeg Free Press print edition February 4, 2013 B6

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