Stock markets around the world have recently been creating fresh records. New highs were notched up this week by the MSCI All-country World Index and by markets in places as diverse as India, China, the US, the Netherlands, New Zealand, South Korea and Germany, before a bout of profit-taking spoilt the party.
What is behind the sudden rise in equity markets across the globe? It’s liquidity all over again, says the Organization for Economic Co-operation and Development’s (OECD’s) latest issue of Financial Market Trends.
How does one measure this elusive factor? The OECD has a formula. It says that high-powered global liquidity measured in US dollars is equal to US base money plus the foreign exchange reserves of central banks in Asia and Europe. According to this indicator, global liquidity reached a peak in the middle of 2004 before starting to slide down precipitously.
Since the beginning of last year, however, it has begun to climb up again. Not surprisingly, the OECD finds a close correlation between this global liquidity indicator and the spurt in private equity deals.
There’s also another reason for the spurt in stock prices. The report points out that within Asia, real interest rates are deliberately held low in order to stimulate growth. The consequence is a massive arbitrage opportunity, “to borrow at low rates and buy higher yielding assets”. In other words, it’s the “carry trade.”
How big is this arbitrage opportunity? Theory says that the process will carry on till the yield from stocks is forced down to the borrowing cost. The yield from stocks is the earnings yield, or the inverse of the price-earnings (P/E) ratio. So for the earnings yield (E/P) to fall, price must rise. That, explains the Oecd, is what is driving stock prices up. As proof, it shows that the gap between earnings yields and bonds in the UK, the Euro area and the US is at present at the highest level since 1990.
Is this sustainable? The Oecd quotes from Didier Sornette’s book on Why stock markets crash, “Think of a ruler held up vertically on your finger; this very unstable position will lead eventually to its collapse, as a result of a small motion of your hand or due to any tiny whiff of air. The collapse is fundamentally due to the unstable position; the instantaneous cause of the collapse is secondary.” That sounds a lot like the crash last February, which started from the insignificant Shanghai exchange.
This is not the first time that global liquidity has been equated with the US monetary base plus forex reserves—Ed Yardeni had done it as far back as 2004, in an article called ‘Super Money and Global Booms’. According to Yardeni, the growth of super money led to global synchronized booms and it was a leading indicator of both dollar depreciation and higher commodity prices. Of the two, dollar depreciation is already here.
But the notion that carry traders will drive up the price of equities till the gap between earnings yield and borrowing cost is eliminated does seem rather academic. For Japan, with its near zero interest rate, that would call for sky-high equity prices. For the Sensex, at its current price-earnings ratio of around 20.8, the earnings yield, or 1/20.8, is 4.8%, well below the borrowing rate. Even if we allow for 20% earnings growth in FY 08, the earnings yield will be 5.8%, still below the overnight borrowing rate. By that yardstick, stocks in India are grossly overvalued.
Earnings yield in Asia
A recent report by Citigroup Asia Pacific compares earnings yield in countries in the region with their 10-year bond yields. China, India, Indonesia and the Philippines are countries where the earnings yield is lower than the yield on the domestic 10-year government bond. India and Indonesia are right at the top of the list, each with a negative earnings yield gap of 3.6 percentage points. At the other end of the spectrum, Thailand, Taiwan, Singapore, Malaysia and Hong Kong have large positive yield gaps—their earnings yields are much higher than their bond yields.
With debt more expensive than equities, Citigroup analysts Markus Rosgen, Elaine Chu and Chris Leung estimate that net debt-to-equity for 2007 of Indian companies is a lowly 13%. That also explains the rush of companies to raise equity.
But why should debt-equity ratios be low in Asian countries such as Taiwan and Korea, where equity is more expensive than debt?
In the US and European markets, whenever the earnings yield has exceeded the bond yield, leveraged buyouts and mergers and acquisitions have resulted, because it makes sense to borrow to take over such companies. The Citigroup analysts argue that this discipline is absent in Asia, because of the large proportion of family holdings in companies. They also point out that the earnings yield gap analysis doesn’t seem to be working very well, since “the earnings yield gap in Taiwan has been positive since November 2003 and yet the market has underperformed the rest of the region, while in China the current earnings yield gap is negative yet local investors remain well engaged.” In India, too, the high negative gap hasn’t deterred FII inflows into equities.
The Citi analysts also give a list of their buy-rated stocks that have high earnings yield gaps. Unsurprisingly, all the Indian stocks that figure on that list are public sector banks quoting at relatively low multiples, such as Union Bank of India, Canara Bank and Corporation Bank.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at firstname.lastname@example.org.