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V. Anantha Nageswaran

Though economic activity has gathered momentum in the US, the Federal budget deficit has reached record levels and looks set to rise further. Deficit spending makes bondholders nervous. However, its effect on the equity market is different. The ultra-easy monetary policy and expansive fiscal policy are boosting the economy and the stock market outlook for now, says V. Anantha Nageswaran.

FOUR weeks ago this column discussed the outlook for US bonds and argued that the outlook for bonds in 2004 was likely to be better as the short-run boost to American economic growth from tax cuts, child tax relief rebate cheques and low mortgage rates would dissipate. The note left with a promise to take up the case for the stock market later. This column delivers on that promise.

Year to date, global stock markets have recorded gains. It is, indeed, striking that both the top and the bottom 10 stock market performers are in positive territory this year. The only difference is that the magnitude is much smaller for the bottom 10. What to make of it? Will the gains continue or dissipate as we move into the crucial months of September and October, when volatility is usually high?

Bondholders fear inflation and deficits

The ultra-easy monetary policy and expansive fiscal policy, that bond investors (correctly) fear, are boosting the economy and the stock market outlook for now. To see why, let us remember that bondholders receive a fixed coupon payment every year.

Hence, any threat of inflation is allergic to bond holders as inflation erodes the real value of the fixed interest income they receive every year.

Bond prices promptly drop when inflation fears spike. Inflation fears arise when economic activity gathers speed, when interest rates are too low and when budget deficits begin to rise. The American economy meets all these conditions now.

Economic activity has gathered momentum in the last two months, the short-term interest rate bottomed at 1 per cent in June and government bond yields bottomed in mid-June.

The Federal budget deficit has reached record levels in absolute dollar terms and looks set to rise further. Last week, the US President, Mr George Bush, requested the Congress for an additional $87 billion to pay for America's continued occupation of Iraq.

When deficits rise, it influences the bond market (or, interest rates) in two ways. One, when private sector looks to raise funds too for its own needs at times of high levels of public sector borrowing, demand for funds rises relative to available pool of savings and interest rates rise.

Second, a high budget deficit raises the fear that governments will erode the real value of debt (that it has to repay) by printing money and creating inflation. To compensate for possible higher inflation in the future, bondholders demand a higher compensation by pushing down prices and yields higher. Hence, deficit spending causes nervousness for bondholders. Its effect on equity markets is, however, different.

Stock-holders do not always

The price of a stock today is equivalent to the discounted value of its future cash-flow (dividends) to stockholders. Both stock prices and earnings are nominal quantities. Hence, inflation could be a good thing for corporate earnings prospects. Inflation signals pricing power for companies and recovery in earnings.

Deficit spending by government boosts short-term economic activity, and, hence, corporate profits too. To the extent that deficit spending and the prospect of a higher inflation cause interest rates to rise, then stock prices would suffer.

However, if the improvement in earnings exceeds the nervousness in the bond market, then stock prices will not only withstand the rise in interest rates but also continue to make gains.

Standard and Poors believes that the "earnings picture is improving faster than the interest rate picture is deteriorating" (Investment Policy Committee Notes, September 3, 2003). If that is the case, then the outlook for equity prices appears to be bright for the remainder of the year.

Are stocks fairly priced now?

Even if corporate earnings look set to improve, stock prices could have already anticipated such a recovery and priced that in. So, at current prices, how do measures of valuation such as Price-Earnings Ratios (P/E) look? That is, based on P/E ratios, do stock prices appear cheaply priced or fairly priced or overpriced relative to history?

One confronts a minefield of issues when we begin to answer these questions. Does one use operating earnings or reported earnings? Answering this question is easier if we know what they are. According to Standard and Poors, the definitions are:

Operating earnings: This measure focusses on the earnings from a company's principal operations, with the goal of making the numbers comparable across different time period. Operating earnings are usually considered to be `as reported' earnings with some charges reversed to exclude corporate or one-time expenses.

As reported earnings: As reported earnings are earnings including all charges except those related to discontinued operations, the impact of cumulative accounting changes, and extraordinary items as defined by Generally Accepted Accounting Principles (GAAP). This is the traditional earnings measure and has a long history, having been used for the S&P 500 and company analyses for decades.

The definitions lead us to prefer reported earnings as the metric for calculating P/E ratios. The next decision is whether one uses historical earnings or estimates of reported earnings. Since stock prices are always discounted values of future earnings, conceptually one has to use future earnings estimates. Two problems arise here. First, reality has consistently trailed the optimistic estimates. Second, earnings estimates are surrounded by greater uncertainty than in the past.

One way to get around this is to use realised earnings for the most recent year in the implicit hope that the next year's earnings would be close to it. It may often not be the case if earnings in the year ended were unusually weak or strong.

Then, the answer is to use the average of the last five or 10 years of earnings. That would smooth out yearly fluctuations. Let us use all the measures — a forecast of the current and next year's "as reported" earnings, reported earnings for the last 12 months, five and 10 year averages of reported earnings to compute the P/E ratio for S&P 500 stock index and see how they compare to history.

They are, but...

The Table is mostly self-explanatory. The columns marked P/E ratios are computed using the S&P 500 Index closing value on September 12, 2003 and earnings figures in the columns to their left. Compared to history, P/E ratios based on the closing value of the stock index on Friday are not low and they indicate that the stock index is richly priced. Obviously, I am comparing the computed P/E ratios to its 68-year history and not to its last 14-year history as it includes the bubble years (1997-2000).

Professor Jeremy Siegel of Wharton argues that a P/E ratio of 20 is justified and, on that basis, the S&P index could climb to a value of 1260 by end-2003, if we believe in the Operating Earnings estimate of USD60.00 for 2004. Optimists would make such a forecast for the S&P 500 Index and, for this purpose, I do not count myself as one. So, if the S&P 500 index is either slightly overvalued or significantly overvalued relative to history, is it more likely to fall than to rise? Alas, if only it were so simple.

Stock market valuations are no more than a reference or a benchmark like the purchasing power parity estimates for exchange rates. Actual values could trade well below or above such benchmarks for many years and anyone who makes investment decisions based solely on valuation considerations is in danger, on many occasions, of feeling too lonely.

They are more likely to be vindicated over the long haul. However, before that, they could lose their bonuses, jobs or both. Keynes said famously that markets could remain irrational longer than investors (who bet on its return to rationality) could remain solvent.

...that may not prevent gains until year-end

Many considerations or forces shape the outcome of the market in the short-term. Currently, most fund managers have experienced losses for three years. They would go out of business if they report negative performance for the fourth year.

They have a strong interest in keeping the indices aloft. So are corporate executives whose stock options would be under water if stock prices go down.

They could encash at least some of their options if prices finish higher. Even workers who have borrowed lots of money in recent years due to low interest rates will find their pension investments swell if stocks finish higher.

Financial television networks will get more advertisements and higher audience following if stocks rise rather than fall. A President due for re-election could point to a stock market recovery as a vindication (?) of his economic policies. Finally, most bear markets in the past have seen a technical recovery in years three and four since their commencement before they begin their final and most painful phase of decline.

In other words, irrational exuberance can and does prevail in the short-term and markets could remain inefficiently priced for a long time before payback time arrives. It means that bubbles could develop and burst with greater frequency than before.

It is due to the absence of neutralising forces that "lean against the wind" during periods of market mispricing. We will examine this in detail possibly in the next column. For now, we can set aside such concerns and enjoy a possibly stronger finish to the year in American and global equities.

(The author is Director, Global Economics and Asset Allocation in Credit Suisse, Asia-Pacific. His views are personal. Please send feedback to anantha@nageswaran.com)

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