Waking up to equity risk
Can the global equity culture survive its first bear market?
We ask all our readers to observe a one-minute silence on March 10th to mark the first anniversary of the Nasdaq peak. Over the past year this index, once the beacon of America's "new economy", has tumbled by 55%. America's broadest stockmarket index has lost more than 20% of its value. Markets around the world are now, on average, at least one-fifth below last year's peak, as share prices have also tumbled from Tokyo to Frankfurt, Sao Paulo to Seoul. Over the past year, around $4 trillion has been wiped off the value of American shares alone, a sum equivalent to 40% of the country's GDP. The collapse in share values after the stockmarket crash of 1987 was only half as big, at 20% of GDP. Welcome to the global bear market, the grizzliest for a generation.
Nowadays, falling share prices hurt economies more than they used to because stockmarkets are everywhere much bigger not just in absolute terms but also in relation to national income. As a result, America's economy may yet face a recession that was not supposed to happen (see article). But is even more at stake than the course of the business cycle in the United States and elsewhere? Might the fall in share prices spell the end of the public's passionate new fondness for equities? If so, that would be a more significant change than you might suppose.
The 1990s will be remembered as the start of the Internet age, but also the decade when the world—not just America—discovered shares. Global stockmarket capitalisation hit $35 trillion last year, 110% of global GDP, up from 40% in 1990. Stockmarkets used to be seen as the reserve of pinstriped brokers and their wealthy clients. No longer. Over half of all Americans now own shares, twice as many as on the eve of the 1987 crash. Share ownership is even higher in Australia, an economy which not so long ago was run by trade unions. In Germany, where cautious investors used to put their money in bonds, one-fifth of adults are now shareholders, twice as many as three years ago. Even poor countries, even communist ones—China is both—have become crazy for shares.
Wider share ownership is profoundly important. First and foremost, it spreads wealth. In addition, it changes attitudes towards economic freedom, by aligning workers' interests more closely with those of companies, so reducing opposition to lower business taxes or measures to make markets for goods and labour work better. Another aspect of the growing equity culture is greater shareholder activism. Continental Europe's new shareholders are putting pressure on managers to improve their performance. More than any one technological breakthrough, this cultural change promises to raise productivity and economic growth. (Indeed, it may even be a necessary condition for the rapid adoption of disruptive new technologies.) A thriving equity market makes it easier for young entrepreneurial firms to raise money. And it reduces the dependence of companies on bank credit—a notoriously hazardous and unstable way to allocate capital.
Will the slump in share prices kill this emerging equity culture? Plainly, it depends on how much worse, if at all, the share-price slump gets, and how quickly it is reversed. Share prices might recover as swiftly as after the crash of 1987. But by many traditional yardsticks they remain overvalued. And just as stockmarkets overshoot at the top, they often undershoot at the bottom.
Falling share prices have already dented enthusiasm for shares in Japan and many emerging markets. But after a pause, strong structural forces should continue to support the equity culture in the long term. In particular, as state pay-as-you-go pension schemes strain under the weight of ageing populations, governments around the world are keen to encourage a shift to private pensions. This will fatten the funds that invest in equities. After an 11-year bear market in Japan it is hardly surprising that less than 10% of households still own shares. Here, too, a rapidly ageing population poses a big challenge to pension finance. In the short term, on the other hand, a severe bear market would make it even harder to privatise state-run social-security systems, such as America's.
Meanwhile, companies are struggling to cope. The supply of fresh equity capital has more or less dried up in America in recent months. This has had severe consequences further down America's capitalist food chain, because venture capitalists rely on the "exit route" of an IPO to get their money back (ideally multiplied many times over). Entrepreneurs with bright ideas are finding it hard to raise funds—a state of affairs that could do serious harm to prospects for further innovation. Small individual investors, especially, have lost some of their enthusiasm for equities. In America, "day trading" over the Internet is not the national pastime it was; these days it is regarded more as a mild form of mental illness. Actually, that is no bad thing. Small investors need to take a cautious long-term approach to the stockmarket.
With luck, the new equity culture will survive, but with added wisdom. The popularity of shares ought to reflect the underlying profitability of the companies that issue them, not delusions of instant riches at no risk. It ought to be guided too by something closer to intelligent analysis than the comments of one American dotcom analyst this week. Asked to explain why his recommended stocks were down 79% since the start of last year, he replied: "The market went from saying, 'We like companies that are growing quickly but are losing a lot of money,' to saying, 'We want to see earnings.' It's very hard to predict a 180-degree turn like that." Actually, it was dead easy to do so. Enough of a bear market to discredit the dispensers of such drivel can only be salutary.
Ups and downs aside, as long as there is a healthy supply of opportunities to make profits, the demand for shares should remain strong. If the bear market reminds "experts" and amateurs alike that risk and return go together, it will have served a useful purpose. And if, having done so, it then immediately goes away, that will be even better.
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Carl
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