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How stock markets and economy are related

Saturday, June 23, 2007

A recent research note by Rob Subbaraman, chief economist for Asia at Lehman Brothers, explores the relationship between the equity markets and real economy in Asia. Subbaraman says equity prices can affect the real economy in four ways: by making households feel richer, as the value of their equity holdings rises, and this ‘wealth effect’ then spills over into higher consumption; by increasing business confidence; by increasing borrowing capacity by raising the value of assets pledged as collateral; and by raising the market cap of a firm relative to the replacement cost of its current assets (a factor known as Tobin’s q) which will induce entrepreneurs to add capacity.

Subbaraman finds that the state of the equity markets is important for the economy in only four Asian economies—Korea, Taiwan, Hong Kong and Singapore. For India, the correlation is not significant. That’s hardly surprising, since equities make up only a 4.3% share of Indian household financial assets, compared with 29% in Singapore, 22% in Taiwan and 19% in Korea. What’s interesting is that Subbaraman argues that if the frenzy in Shanghai continues, the share of equities in Chinese household financial assets will jump from 4.5% in 2005 to 8.7% by the end of this year. China’s market will then “no longer be a sideshow for its economy”. When that happens, global markets won’t be able to shrug off the dramatic swings in the Chinese stock markets quite so blithely.

There is plenty of research that points to the importance of deep financial markets for economic growth. Unfortunately, the empirical evidence is hardly supportive. China, for instance, has managed to sustain a blistering pace of growth with very underdeveloped stock markets. Earlier, South Korean and Japanese growth too did not depend on the health of their stock markets. But while the secondary market may not have an appreciable impact on the economy, surely the primary market does, through IPOs and follow-on offers?

Indian companies raised $7.23 billion (Rs29,643 crore) from the domestic capital markets last year, or around 7.5% of the increase in non-food bank credit during the year. And China’s raising of $56.6 billion from global markets last year certainly had an impact on its economy, as it’s a significant proportion of its bank credit growth. More interesting, however, is the impact of economic growth on stock prices. One of the main reasons for the attraction of the Indian market lies in the high growth rates for the economy, which leads to higher corporate earnings. That’s the reason investors from all over the world are pouring their money into Indian equities.
Could they be mistaken?

Economists researching the subject have argued that high economic growth is by no means a guarantee of high stock returns. A study by Jay Ritter of the University of Florida on ‘Economic Growth and Equity Returns’ found: “It is widely believed that economic growth is good for stockholders. However, the cross-country correlation of real stock returns and per capita GDP growth over 1900-2002 is negative. Economic growth occurs from high personal savings rates and increased labour force participation, and from technological change. If increases in capital and labour inputs go into new corporations, these do not boost the present value of dividends on existing corporations.” “Countries with high growth potential do not offer good equity investment opportunities unless valuations are low.” Historically, says Ritter, much of economic growth has come from infusion of capital into new firms, a conclusion that ties in with the large number of IPOs by Indian and especially by Chinese companies.

As US finance guru William Bernstein has pointed out, “The bad news is that if a nation’s economy grows at x% per year, per-share earnings and dividends do not also increase at x% per year—they increase at (x% - y%) per year, where y% is the amount of share dilution.” Also, in a competitive economy, the benefits of technology are usually appropriated by consumers. A couple of years ago, a study by ABN Amro Bank and the London Business School found a negative relationship between per capita GDP growth and stock returns between 1,900 and 2004 for 17 countries.

Professors Elroy Dimson, Paul Marsh and Mike Staunton of London Business School, commented: “Investors who allocate assets to countries with high expected GDP growth do not, on average, achieve superior returns. Historically, buying into equity markets with a high GDP growth rate has given a return that is below the return of markets with a low GDP growth rate”.
So why do investors continue to flock to emerging markets?

Here’s the answer: Over the period 1951-1980, the period which marked the phenomenal rise of Japan, the Nikkei rose from 102 to 7116, a rise of 6,876%. Over the same period, the FTSE all-shares index rose from 41 to 292 and the Dow from 235 to 964, increases of 612% and 310%, respectively. But perhaps taking 1951 as the base is not right and the rise reflects Japan’s recovery from the destruction caused by the World War. Well, even if we take the two decades between 1961 and 1980, the Nikkei went up by 424% over the period, while the FTSE and the Dow went up by 186% and 56.5%, respectively. At least so far as the Japanese experience is concerned, rapid economic growth did result in superior stock market performance.

source: mint

Posted by FR at 10:55 PM  


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Investment in equity shares has its own risks. Sincere efforts have been made to present the right investment perspective.The information contained herein is based on analysis and up on sources that we consider reliable. I, however, do not vouch for the accuracy or the completeness thereof. This material is for personal information and I am not responsible for any loss incurred based upon it.& take no responsibility whatsoever for any financial profits or loss which may arise from the recommendations given in this blog.