Stock Prices in the UK and the US - Term Paper Example

During the 1990s, Nearly all FTSE 100 and S&P500 Companies Failed to Reach Pre and Post-tax Return on Capital Employed Targets Set by Large Investors. 1.0 Introduction: During the last half of the year 1990 the US and UK stock markets witnessed a huge increase in the stock prices relative to earnings. However analysts claim that there are no obvious reasons for such increase in the prices of stocks which can be attributed as relative to the increase in the earnings of the companies. Obviously increased productivity growth could not be cited as a factor for this phenomenal increase of stock prices, because there was only a moderate increase in the long-run productivity growth in the last half of the year 1990. Moreover there were no significant changes in the earnings growth and share of earnings in the economy which could have resulted in the increased share price index. However the sharp price increases in the stocks might have been the result of factors like irrational over-enthusiasm on the part of the investors, lower interest rates and higher level of savings by the middle-class and the consequent increase in their investment in stocks. Apart from these reasons, the relationship between the earnings increase and the stock price increase was negligible. Hence the expectations of the large investors in their setting higher target levels on the return on capital employed from those firms in which they held the investments on the assumption that the share price increases would automatically increase the earnings would hold no ground. While the factors responsible for the share price increase are totally different from the performance of these companies it would be illogical to expect the managements of the large companies to service their shareholders with larger returns on the capital employed based on the share price performances. With this background this paper examines the rationale behind the statement that during the 1990s, nearly all FTSE 100 and S&P 500 companies failed to reach pre and post-tax return on capital employed targets set by large investors and the managements of the giant firms during 1990s should be considered responsible for the mediocre return of capital employed as well as the moderate growth of sales of their firm in spite of the higher stock prices. 2.0 Reasons for Stock Price Increases: As outlined earlier the stock price increases during the 1990s were caused by factors like "Irrational Exuberance' on the part of the investors, declining interest rates and higher level of stock market investments out of savings by the middle classes. The signs of greater economic stability prevalent during the period convinced both the business managers and the investors to take extra risks which later resulted in both positive and negative consequences. Let us analyse the reasons for the increase in the share prices. 1. Irrational Exuberance on the part of the investors: Coined and used by the Federal Reserve Board Chairman Alan Greenspan as a word of caution against the repercussions of the stock market boom, denotes a warning that the market might have been overvalued and a natural consequence, slumps in the prices of the stock was inevitable. "The term "irrational exuberance" is often used to describe a heightened state of speculative fervor." (Robert J Shiller 2000) Irrational exuberance is defined by Shiller (2000) as the psychological basis of a speculative bubble. The speculative bubble on the other hand is the situation where the potential investors are lured by stories justifying the share price increases, who irrespective of their doubts about the real value of the assets continue to invest in the stocks. This luring is also partly due to the excitement created by such investments which resemble gambling and partly owing to the envy of the investors on the others' successes. This might be the main reason for the stock market boom that the world witnessed during the 1990s. 2. Declining Interest Rates: One of the other reasons, though not major, that was attributed to the share price increases was the declining interest rates which had some effect on the stock prices. "Indeed, with declining interest rates one might well think that stock prices should be rising relative to earnings, since the prospective long-term return on a competing asset, bonds, was declining, making stocks look more attractive in comparison." (Shiller 2000) This relation between the stock market and the interest rates was referred to as 'Fed Model'. However the Fed Model suffered from a weakness that even after peak of the market in 2000 the price-earnings ratio and interest rates were continued to fall without any increase in the share prices. 3. The fact that there was a wide spread redistribution of money and power in the form of wealth accumulated in the hands of the US and UK households. In fact this group represented the majority of the investors and the affluence created by such accumulation of wealth made them to invest more in further shares due the taste of the money already earned by them. "There has, however, been a real shift in focus, so that the beneficiaries of corporate success (such as it is) are no longer the workers and the general public as a whole but shareholders." (Larry Elliott 2006) The majority of the shareholders were the higher middle class. Although the above could somewhat be attributed as the reasons for the increase in the share prices, there is no other justifiable reason for such increase from the year 1994 to 2000.There were no economic indicators which would explain the increase in the share prices. Similarly during the same period there was a 40 percent increase in the GDP of the US and a 60 percent increase in the corporate profits. That too was the result of a relapse from a previous recession. Hence even viewed in the light of these figures, the stock price increase appears unwarranted. Hence the expectations of large investors that the share price increases were the result of the superior performance of the corporate and with the result that the companies should be able to service a higher rate of return on the capital employed by reason of such higher level performance can not be considered reasonable. 3.0 Effect of the increase in share prices on the Earnings: As a general theory, the increase in the share prices was the result of the high propensity for risk-taking. Similarly the increased pace of innovation that was prevalent during the 1990s indicated further prospects of earnings growth. This expectation of earnings growth resulted in the increase of stock prices. "The associated decline in the cost of equity capital spurred a pronounced rise in capital investment and productivity growth that broadened impressively in the latter years of the 1990s." (Alan Greenspan 2002) This gave a fillip to the stock prices owing to the growing optimism about greater economic stability, profitable and safe investments and faster productivity growth of the corporate entities. However the euphoria resulted in pushing the prices to such levels that the fundamentals of the companies were not strong enough to support the surge in prices. Between the years 1995 and 2000 the price-earnings ratio of S&P 500 had doubled from 15 to nearly 30. However this upswing in the price-earnings ratio was not supported by the growth in real earnings. Only if the growth in the real earnings was revised upwards by 2 full percentage points in perpetuity, would it have supported the price-earnings ratio. Thus the real earnings fell short of the large investors' expectations. This is evident from the pictorial representation in the form of the graph below: Source: Irrational Exuberance Robert J Shiller (2000) From the graph it may be observed that the earnings during the 1990s were not corresponding to the increased levels of the stock prices. Historically the stock price of a company was reflective of its growth in earnings. This was because when a company performed well and showed an increase in rate of growth in earnings, more people invested in the company. This drove stock prices to higher levels. However during the 1990s this was not the case. Stock prices ceased to be reflective of the growth in earnings of a company. This is evident from the graph where we see that the surge in stock prices outstripped the growth in earnings. This was because the prices were driven upwards for reasons other than growth in earnings as explained previously. Large investors, however, were not aware of the fact that factors other than growth in earnings had influenced stock prices. Thus they continued to expect greater returns on investments as was indicated by the high stock prices. When they received returns on investments corresponding to the growth of companies it was far less than the expectations that investors had based on the higher stock prices. 4.0 Effect of Economic Factors on the Earnings: Another important reason for the continuance in the expectations of the large investors for a much higher rate of return on the capital employed is the absence of the revision in economic policies of the respective governments to take corrective measures for checking the spiraling stock prices, fully knowing that what would follow is a period of correction resulting in a slump of stock market prices. In the words of Alan Greenspan (2000) the Ex Chairman of the Federal Reserve "it seems reasonable to generalize from our recent experience that no low-risk, low-cost, incremental monetary tightening exists that can reliably deflate a bubble". He is of the opinion that it was a real challenge to study the developments of the economy and financial markets during the 1990s. This had resulted in strange economic encounters for the policymakers themselves. He further states that the knowledge about such a state of the economy was only theoretical and the policymakers could not identify one policy that could at least limit the size of the bubble so that the investors would have been forewarned about the possible outcome of the increased stock prices. 5.0 Lower Cost of Equity and Riskier Investment Decisions: With the abundance of the availability of the equity finance owing to larger investments, the cost of equity capital was comparatively cheaper. The availability of low cost of equity is triggered by the risk appetite of the investors to shift their investment pattern to hold more high yielding equity rather than low yielding debt. Due to the availability of the cheaper low-cost equity, the managers decided to finance a larger proportion of the capital into riskier real asset proposals. While doing so they did not think about the cash flow situations and the resultant chances of making default in debt repayments. As a repercussion, such large investments made with a certain calculations of cost of debt and equity were proved wrong in the course of time and resulted in lower growth of earnings for the corporations. 6.0 Conclusion: Stock market bubbles often develop wrong perceptions among the investors about the real improvements in the productivity and the resultant profitability of the corporate entities in which they invest. This is what has happened in the 1990s about the large investors who were holding stocks in giant companies registered in FTSE 100 and S&P 500. They had wrong perceptions over the return that they can expect out of these companies by correlating the earnings growth potential and the stock price increases. From our discussions, although the large investors could assume that a higher stock price would automatically result in a higher returns (owing to their assumption that the increased share prices were due to the increased performances of the companies), the real factors which contributed to the share price increases did not put themselves into any economic or other reasoning except that they could be classified as a 'bubble'. Under such circumstances there is no surprise in the statement that during the 1990s, nearly all FTSE 100 and S&P500 companies failed to reach pre and post-tax return on capital employed targets set by large investors. The only thing that can be stated about this phenomenon is that the giant companies performed normally and achieved a rate of growth which could be considered reasonable, but only the return targets were kept at higher levels, without reference to the underlying factors for the increase in the share prices. However it can also be stated that "US or UK giant-firm management can neither take the credit for the general increase in share prices during the 1990s, nor entirely avoid responsibility for mediocre rate of capital employed in many firms or for modest aggregate sales growth in any group of giant firms over the same period", (Larry Elliott 2006) implying that the companies could have performed much better in the available circumstances Reference: 1. Robert J Shiller (2000) Irrational Exuberance Edition 2 Princeton University Press http://www.irrationalexuberance.com/definition.htm 2. Larry Elliott (2006) Nice work if you can get it: chief executives quietly enrich themselves for mediocrity The Guardian January 23 2006 http://business.guardian.co.uk/story/0,16781,1692554,00.html 3. Alan Greenspan (2002) Economic Volatility Speech at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming http://www.federalreserve.gov/boarddocs/speeches/2002/20020830/ Read More