A GLOBAL equity bull market is vital to encourage renewed growth of the global economy. So much so that governments, companies and stock exchanges need to become far more inventive to encourage long term investments in stocks. Equity markets need to be on an upward path so that corporations can raise capital relatively cheaply to expand business, production, sales and jobs.
To be sure, an increase in equity capital ensures that businesses – from banks to grocers – have conservative, sustainable finances. Instead, present government policies in the US and Europe encourages debt instead of equity. Earnings yields (the inverse of price earnings ratios) and dividend yields are generally higher than the yields on both government and corporate debt. This implies that the cost of raising equity capital is higher than debt and it is not surprising that growing numbers of companies are issuing corporate bonds to meet financial needs.
Global markets have recovered from their bear phase lows of late 2008 and 2009, but after five years, almost all stock indices and individual shares are still below the 2007 to 2008 bull market peaks. In the meantime, earnings and dividends have increased, so equity values have improved. Despite the growth in earnings and dividends, initial public offerings of new equities and rights issues have fallen in tandem with shrinking of volumes on Wall Street, European and Asian exchanges. Pension funds, other institutions and individual investors have cut back share purchases and have either chosen bonds, property or gold or kept relatively high levels of cash.
Slack business conditions and fears that a bear market could return have discouraged investment in the stock market. Another key fundamental factor is that policies of central banks, corporations, stock exchanges and governments have contributed to excessive short term speculative trading. The inevitable result has been an increase in volatility and uncertainty that have dented confidence.
Fearful investors have withdrawn from markets and individual stocks that have tended to soar or slump for invariably illogical or silly reasons. High frequency, hedge funds and proprietary dealers of investment banks have benefited from this environment and have dominated trading, accounting for 70 per cent or more of total market volumes, according to the 2012 Kay Review of the UK stock market and other studies.
Quantitative easing (QE) has aggravated the problem as the bulk of institutional and individual investor cash, which now earns virtually zero interest, continues to flow into fixed income securities.
These flows have encouraged companies to issue bonds at historically low yields which could ultimately precipitate a dangerous cycle of burgeoning debt. Thus the issue of a large number of bonds instead of equities and pleas of politicians for banks to lend more, regardless of business strength, encourages companies and individuals to revert to the former bubble days of relatively high leverage.
Current long and short term interest rates are lower than during the former boom years and during a business recovery this leverage can raise a company’s profits. In a downturn, however, the debt levers work in reverse and accentuate any profit decline.
Despite this danger, government policies still favour borrowing instead of equity capital as the interest on debt is tax deductible for companies. Equity holders, on the other hand, incur a triple whammy of corporate profit tax that reduces earnings per share plus capital gains and dividend taxation. The UK government raised capital gains taxation from 18 per cent to 28 per cent in 2010, while the marginal tax rate on dividends is 40 per cent. So far, this policy has failed to dent the budget deficit and time will tell whether the higher taxation will be a disincentive for corporations.
Moreover, foreign companies such as Amazon and Starbucks have avoided tax by channelling UK revenue to offshore centres. Remarkably, the Obama Administration and other US Democrats seem to have ignored the UK case study and want a substantial increase in capital gains and dividend taxation. It would be a far better idea for governments to cut corporate taxation to encourage local and foreign companies to invest more and generate jobs and taxable revenues onshore.
Moreover, capital gains tax could be on a sliding scale so that the longer the period of investment in equities, the lower the tax. To discourage excessive borrowing, interest should no longer be tax deductible while dividend taxation should be on a sliding scale to help hard pressed pensioners and the growing throng of baby boomers.
Corporations with sufficient cash flow should also encourage investors who are desperate for income, by regularly raising their dividends. Unfortunately companies that are trying to encourage investors to buy their equities are encountering problematic analysts and fund managers with an ultra short term horizon. Pension funds and other long term investors do their utmost to value stocks, but they are frustrated because hedge funds and other short term traders are increasingly following the opinions of analysts, instead of actual results and corporate directors.
The result is that they have to make virtually impossible guesses on whether analysts are going to recommend purchases or sales of stocks, prior to and after earnings reports. Quarterly reporting of US, and to a lesser extent European and Asian companies, was originally aimed at improving transparency of the businesses.
Instead, the law of unintended consequences has come into play. Under pressure from analysts, directors now have to forecast revenues and earnings. Analysts, who generally have had a poor track record over the years, tend to be overoptimistic during growth periods and pessimistic in a slack business climate. Even if revenue and earnings rise in a quarter, the stock price invariably slumps if the profits do not match optimistic figures churned out by the analysts.
The reverse applies when company results exceed the so called “consensus” forecasts. The hedge fund and trader crowd thus have a field day in pushing the stock price up and down when analyst predictions and figures either exceed or miss their targets. The consequence, however, is the flight of genuine potential long term investors.
Paul Polman, Unilever’s chief executive, has rebelled against this ludicrous system. He has stopped publishing full financial results every quarter and refuses to offer earnings guidance to the gaggle of equity analysts. Short-termism discourages long term investment and employment, he maintains. Since investors now have to guess what analysts are thinking and how hedge and high frequency funds will react, many have become fearful of investing in individual equities. Growing numbers of investors are placing money in index securities such as exchange traded funds (ETFS). The problem here is that ETFs drive up or down equities of both strong and weak companies.
Moreover, high frequency funds arbitrage against index values by buying and selling individual stocks in nanoseconds ahead of other investors. If exchanges continue to accept sloping playing fields, regulators should still insist that they level the ground.
Market and media attention is focusing on the so called US fiscal cliff and risk that higher taxes and lower government spending could cause a recession in the US and abroad next year. Investors are thus still buying bonds. At current low yields, however, bonds are potentially more dangerous than equities. Yields can rise and capital values can fall in the current stagflationary environment in developed nations and accelerating inflation in emerging countries.
Thus for example, the 10 year US Treasury bond yield is only around 1.6 per cent and is below US inflation of 2.2 per cent. If the yield rises to a still unimpressive 2.6 per cent, the capital loss on the bond will be more than 9 per cent. Corporate, high yield junk and other bond prices would decline in tandem with government securities and also possible credit risks. Equity values are not remarkable, but, as the table shows, both earnings yields ( the inverse of the price earnings ratio) and dividend yields are higher than bond returns, while cash earns almost zero income.
© Neil Behrmann – author Trader Jack-The Story of Jack Miner