What does all this mean for the Stock Market ?

The Deutsche Morgan analysis highlights the absolutely crucial role of interest rates in providing the basis for the market’s strength in recent years (underscored by the substantial growth of corporate profitability), together with their ongoing vital significance in determining its future direction. Further falls in interest rates would provide a justification for the market to move ahead. Rises in interest rates would provide the basis for the market to fall.

So for a little insight into the likely future direction of stock markets — in both the United States and Australia — keep a close eye on the trend in fixed interest markets, particularly in the US. The most likely factors to cause interest rates in the US to move upwards are a sharp strengthening of economic activity and/or any signs of a resurgence of inflation.

What does it mean, when share markets have a big one-day fall and newspaper headlines report sudden huge losses by investors? "Share values slashed by $32bn" reported a national newspaper after the Australian market, under the influence of Hong Kong’s dramatic decline the same day, produced a big fall on Monday October 27.

Such headlines refer to the decline in the value of all the securities (mainly shares) listed on the exchange from one day to the next — that is, the "capitalisation" of the market. In the instance quoted, the decline reflects the fall in prices from the close one day to the close the next.

The capitalisation of stock exchanges is calculated on prices at a given point in time. For a particular listed company, the capitalisation is calculated by multiplying the number of shares it has issued by the share price. The total capitalisation of the market is simply the capitalisation of all the listed companies added together.

Capitalisation figures are purely notional, applying the prices at which a possibly insignificant proportion of companies’ shares have traded to all of their shares on issue. Such figures for "value" are indicative rather than actual. It is certain that not all shareholders would be able to achieve the market price used in the calculation of capitalisation if they all sought at once, or in a short time, to sell their shares. We have had a reminder very recently, most vividly in Asian markets, of the effect on prices when a large number of investors rush to sell shares.

For shareholders who consider themselves long term and are disinclined to trade on the market, short term changes in share prices and market value are little more than hypothetical. While none of us like to see a decline in the value of our share portfolios, the main requirement of long term investors is that share prices recover well from periods of decline to produce satisfactory returns in the long term.

Short term traders, investment funds competitively locked into three-month performance rankings and any investor who has borrowed money to buy shares at higher prices have greater cause for concern at market dips of uncertain duration.

Recent events have caused all stock watchers to focus on the role of "market psychology" in determining investor behavior and the role of confidence — a totally intangible factor — in the valuation of shares.

One aspect of stockmarkets that has been subject to discussion, both before and after the Asian markets shakeout, is the so-called "wealth effect" of changes in market levels.

Stockmarkets, together with property markets, represent a large proportion of the wealth held by investors. Marked changes in share or property values inevitably have a significant impact on the level of investor wealth: this is particularly the case when a proportion of property or share holdings is financed through borrowings. When stock or property markets are buoyant, investors feel much wealthier than when they have fallen or are depressed: on paper, at least, they are.

If investment gains are not realised through sales at the higher available prices, investors will usually have no extra money in their pockets. However, because investors feel more wealthy, they start to act as if they are and spend accordingly. Readers will recall the lifestyles of a handful of Australian stock market "entrepreneurs" in the 1980s, prior to the crash, and how different life became for most of them.

The collective profligacy of investors showing gains on their share or property investments is encouraged, to an extent, by the conduct of banks. Traditionally, banks have lent to borrowers primarily on the basis of loans being secured by property. In more recent years they have accepted other forms of security for loans, including shares. "Margin lending" is based on this development.

The impact of leverage can cause an extended strong bull market’s wealth effect to unwind rapidly when the market falls. This can be particularly pronounced when share and property markets have boomed together, as occurred in Tokyo until 1989 and in other Asian capitals until October 1997.

In these circumstances, the deflation can be marked following an extended period when the wealth effect has been a key factor in the financial sector and economic activity. This is because banks are inevitably affected by the tremors caused when wealth is decimated as share and property values collapse.

At such a stage serious banking crises may develop, requiring either innovative national policy (Japan) or intervention by the International Monetary Fund (several of the erstwhile Asian tigers). Either way, recession in some form is inevitable as a result of the need to restructure over-extended financial systems.

The scale of the collapse of the wealth effect in a number of Asian countries appears likely to cause an extended slowdown of economic activity in the region. The previous wealth effect driving Asian market ever upwards is now in tatters and in reverse gear. The US version of the wealth effect remains intact — for now at least.

Is the Market Overpriced?

Is the market overpriced? Or does it still represent reasonable value? The answer will depend on who you ask and, more importantly, what you ask and what your chosen expert focuses on in providing a response.

It is a matter of record that Wall Street and the Australian market are, despite easing recently, still not far off record levels, as measured by share price indices. The Australian market, when measured in terms of average price earnings ratios based on forecast earnings for leading industrial stocks, is as expensive as it has ever been. Considered on the basis of these criteria alone, there would seem to be good cause for nervousness about the market’s ability to sustain current levels.

But this analysis ignores the influence of interest rates on share prices, in turn a function of the relationship that exists between interest rates and share yields in basically deregulated financial markets. As we know, interest rates are at their lowest level for many years.

If we evaluate the stockmarket on the basis of a comparison of the current level of earnings yields on shares with yields offering on bonds, a different interpretation can emerge. On this basis, shares could be described as under priced

Liquidity and Volume

The relevance of liquidity and turnover levels is easy to overlook when assessing a stock, or an entire market. Liquidity refers to the availability of shares in a company. Volume describes turnover, or trading levels, in a stock.

BHP and NAB are the two most liquid stocks on the Australian market. Thousands of investors have shares in them; the stocks are actively traded in every market session.

In contrast, the shares of many smaller companies, particularly those with major or controlling shareholders, normally trade both irregularly and in small volumes, with the price tending to fluctuate from one transaction to the next. The lack of liquidity is a feature of the market in such stocks.

Clearly, the level of turnover in a stock or a market will be strongly influenced by its liquidity.

The daily newspapers’ sharemarket trading summary pages detail the number and value of shares traded each day for the overall market, major sectors and, in the share lists, of all listed companies.

Investors who have dabbled in thinly traded smaller companies will know that a stock’s liquidity can decisively influence the direction of its price in the short term. Just one or two active buyers or sellers can represent the total market in a stock for a period and be decisive in determining where the price goes.

Because the shares of smaller companies are infrequently traded (sometimes going for days, even weeks on end, without a serious buyer or seller in sight), investors intending to deal in such stocks, either as buyers or sellers, need to take special care about how their orders are placed on the market.

When dealing in these stocks, it helps if the investor has an established relationship with a broker. If readers who are new to the market intend to be active in the smaller companies area, they should invest some time in choosing and establishing a relationship with a broking adviser.

Specific price limits should normally be given with buying or selling instructions to the broker, so the price you pay, or get, does not end up out of the range you intended to trade at. When orders are active, the market should be watched for potential buying or selling interest, or to amend your price range. Your broker may need to refer back to you for further instructions as buyers or sellers become apparent, or to amend limits if nothing appears to be happening.

It pays to be both patient and opportunistic when dealing in thinly traded stocks: patient because it may take days or weeks to attract a serious buyer or seller to meet your bid or offer, and opportunistic because if a buyer or seller does appear, you may need to act quickly, adjusting your price according to circumstances, if you want to do a deal.

The shares of most larger companies are comparatively liquid. Substantial volumes of shares are traded every day in big companies. The market for the shares of these companies is characterised by the continuing involvement of brokers representing numbers of buyers and sellers, large and small, continually trading (both buying and selling) the companies’ shares.

By international standards the Australian stock market is not particularly liquid. More than anything, this reflects the fact that it is comparatively small, representing about 1.5 per cent of global stock market capitalization. Only the larger Australian companies provide the degree of liquidity required by international fund managers to allow transactions of the size they normally undertake.

This means that offshore investors focus mainly on the industrial and mining leaders when they invest in the Australian share market. The concentration of overseas interest in a comparative handful of large companies and the mining sector means a tendency towards a two-tiered local market, at least in valuation terms, with prices of the leaders being more immediately subject to international influences than the prices of smaller companies.

The comparative smallness of the Australian market is a contributing factor, together with its substantial resources exposure, to its historical performance being more volatile than that of larger world markets. This is paralleled within the Australian market by the generally more volatile performance of the smaller companies sector compared to larger stocks.

Part of the reason why less liquid markets are more volatile is that by nature they fluctuate more dramatically on changes in market sentiment than larger markets. The limited availability of shares means that, for example, a surge of buying interest is likely to flush out all immediate sellers while not satisfying all the buyers: to obtain stock, buyers must bid up the price to induce new sellers into the market.

Similarly, a large number of selling orders will tend to swamp less liquid markets, placing strong downward pressure on the price until buyers reappear.

How Imputation Works -

A company’s dividend cheque includes an explanation of how much of the dividend is franked and the dollar amount of the imputed tax credit being passed on.

As an example, using the 36 per cent company tax rate, assume that an investor’s franked dividend represents $10,000 of pre-tax company profits. The company will have paid $3600 tax on that, leaving a $6400 dividend, with the $3600 attached as a tax credit.

The shareholder must declare as income not just the $6400 but the $3600 tax credit as well — that is, the original $10,000 profit the company made. For a shareholder with a marginal tax rate of 47 per cent, it works like this:

Tax payable at 47 per cent on $10,000 = $4,700

less franking rebate $3,600

Net tax payable $1,100

Put another way: taxpayer A gets a fully franked dividend of $6400. Taxpayer B, who is in a higher income group, also gets a $6400 dividend, of which only 80 per cent is franked.

Taxpayer A actually pays considerably less tax ($922) after getting the dividend than would have been payable without it ($1920). Because the taxpayer’s average tax rate is under 33 per cent, the excess franking rebate offsets other tax. Following amendments to the marginal tax rates for individuals, taxpayer A has a marginal tax rate for 1995-96 of 34 per cent. This applies to taxable income from $20,700 to $38,000. For taxable income from $5401 to $20,700, the marginal rate of tax is 20 per cent. Thus, taxpayer A has $4300 of taxable income in the higher marginal tax bracket and can still offset the excess franking rebate against other income.

Taxpayer B has paid $1282 more tax after getting the dividend. But the dividend was $6400, so this is a rate of about 20 per cent, compared to up to 47 per cent (over $50,000) that would be payable as the marginal rate on other types of income — including interest from bank deposits, government securities and debentures.

Dividend Imputation and Franking Rebates

Shares have an established record of providing long term capital growth. Dividend imputation adds the significant benefit of reduced tax on share dividends, enhancing after-tax returns.
Its most important feature is that individual shareholders and superannuation funds get a rebate that reflects tax the company has paid on income paid out as dividends — the "franking" rebate. Depending on their tax status, dividends are referred to as fully franked, partly franked or unfranked.
Dividends are usually franked, meaning that tax paid by most investors on their dividend income will be significantly less than tax on a similar level of income from most other investments, including government securities, bank deposits and debentures. This can mean that the net yield obtained from shares can compare very favorably with the net yields from other forms of investment — with shares having the added attraction of potential for long term capital growth.
The effect of dividend imputation on individual shareholders depends mainly on two things: the individual’s taxable income and how much tax the company has paid before distributing the dividend.
Most companies pay tax, and pass on franked dividends to shareholders. Most large industrial companies pay enough tax to attach a full tax credit to their dividends, making them fully franked.
A fully franked dividend means that the whole dividend carries a tax credit at the applicable company tax rate. This provides the maximum benefit of dividend imputation to shareholders.
A company’s tax circumstances can change and, consequently, its ability to pay franked dividends. Companies may claim various tax deductions, including losses from previous years. This means a company does not always pay the full rate of tax on its profits in a particular year.
The result may be that the company has not paid enough tax to attach a tax credit to the whole of the dividend it pays. Then, a tax credit is attached to only part of the dividend: the dividend is referred to as partly franked. A shareholder who gets such a dividend pays the usual income tax on the part that is unfranked but is able to claim a tax credit for the franked portion.
Companies that pay franked or partly franked dividends provide details with the dividend cheques sent out, to help shareholders file their tax returns.
The extent of the benefits of franking credits will depend on an investor’s marginal tax rate. If it is higher than the company tax rate at which the tax credits have been calculated, the shareholder will have to pay tax only to the extent needed to make up the difference between his or her marginal rate and the company rate.
If the shareholder’s marginal tax rate is lower than the company rate, not only will no tax be payable on the franked dividend, but the shareholder will get a tax credit that can be used to offset tax payable on other income.
If a shareholder’s total income is below the tax threshold, franking credits are of no value. Excess franking credits cannot be carried forward.

How to buy and sell shares

Many people who are new to the investment game — perhaps their interest has been fired by reading Shares — have never had anything to do with the stock exchange, let alone a stockbroker. While they may have an inclination to buy shares, they might imagine that the whole process is a little daunting.

Many people have fairly significant investments in the shares of a range of companies but have had extremely little, or nothing, to do with stockbrokers.

Often an inheritance can provide an individual’s first experience of the stock market.

An increasing number of people have become investors for the first time by applying directly for shares in one or more of the new company floats, recapitalizations, privatizations in recent years. The great majority of such new investors are now sitting on very tidy "paper" profits on their investments. Some might be inclined to sell but are unfamiliar with the procedure involved.

Once a company has floated and issued shares to shareholders, the usual way in which shares are bought or sold is on the exchange.

Normally, the buying and selling of shares in companies listed on the stock exchange is undertaken through a stockbroking firm. So the first step is : find yourself a broker. You may have friends who can suggest a broker to you, based on their own experience. If not, you can get on to the telephone and make your initial contact.

If you wish to discuss your investments, or are intending to buy or sell shares, the person to whom you should speak at the stockbroking firm is one of its investment advisers. Policies concerning the opening of client accounts and the manner in which a firm deals with initial buying or selling instructions from clients (for example, any deposit to be lodged before buying) vary from firm to firm, so it is best to discuss these issues with the adviser.

Stockbroking is a customer and service-oriented profession. It is also a competitive industry. If you don’t like the advice, or the vibes, you get from the first adviser you approach, try another adviser, or another stockbroking firm.

The "brokerage" (that is, commission) rate and manner in which brokerage is charged on buying and selling transactions varies between stockbroking firms. Charges can be discussed in your initial contact with the adviser.

Stockbroking firms do not charge for advice offered, or for client interviews. Basically, stockbrokers earn their money from brokerage on transactions.

Some investors are not interested in receiving advice or any other service from a stockbroker. Their principal interest is simply to have a broker who will dutifully receive and execute buy and sell orders. For such investors, one of the growing number of non-service discount brokers who charge a flat rate for the execution of orders could well be an appropriate choice. Such brokers advertise their services in this magazine and the daily financial press.

Understanding the stock exchange

As you flick over the share lists in your daily newspapers, many of you would strike blanks when it comes to having any understanding of the concept and role of the stock exchange. Even some people who are investors in shares may be unclear as to the stock exchange’s function.

So why do stock exchanges exist? What is their function and why do companies list their shares on the stock exchange?

Listing on the stock exchange is not without burdens for companies. There are stock exchange reporting requirements to be satisfied and the need to establish and manage costly share registers. There is also a greater level of scrutiny of activities and management (particularly by investment analysts and the media) than in the case of unlisted companies. The stock market can do funny things to share prices and there is, for many companies, a real prospect that they could be taken over. Yet companies still choose to be listed.

Stock exchanges have been around for at least seven centuries, since the Italian city of Florence converted some of its loans to securities that were tradeable. Some experts claim share market-style trading dates back to the ancient Greeks and beyond.

Their rise to prominence came with the industrial revolution, when new methods of production required investment in plant and machinery beyond the means of wealthy individuals or families. This led to the rise of "joint stock" companies, owned by numerous investors who had pooled capital for their establishment. Australian law has its roots in British law, but for a long period in Britain — until well into the 19th century — the law in relation to companies was quite unclear.

Over time, the roles of the stock exchange and corporations became progressively more recognized in law, to reach the level of centrality they have today. Globally, the company is a basic unit of industrial organization, and stock exchanges play a pivotal role in the supply and exchange of capital for companies.

Companies thus came into being as a means of assembling capital for the development of businesses on a much larger scale than could otherwise have been possible. Without corporate structures, many of the good ideas of inventors and innovators, from James Watt to Henry Ford to Bill Gates, may well have remained just good ideas, left on the shelf because the capital required for their application was not available.

The development of stock exchanges was inevitable as companies became the basic units of business organization.

In essence, a stock exchange is a marketplace serving two important functions.

The first is that it is effectively a meeting place where "entrepreneurs" (usually in the non-pejorative sense of the word) seeking to raise capital for specific commercial applications can link up with investors who are willing to supply some of their available funds by becoming part-owners — "shareholders" — of an entity that has been created to fulfill such objectives. In this fashion, the stock exchange plays a crucial role in the provision of the capital required for the formation of companies. This is the primary function of the stock exchange.

The float of BHP on the stock exchange in 1885 was a good example of the stock exchange fulfilling its primary function. Another example of the stock exchange’s primary function in action is when BHP seeks to expand its capital base (as it has from time to time) to support the funding of new ventures and makes a cash share issue to its shareholders.

Investors will be much more inclined to subscribe capital for a company when they know they can readily sell their investment if this becomes their desire — particularly if the price at which they can sell may reflect the success of the company in which they have invested, giving the opportunity for profit. The provision of a market on which shares can be exchanged between buyers and sellers is the secondary function of the stock exchange.

Casual observers could hardly be blamed if they overlook the stock exchange’s primary role, because the focus of day-to-day activity, and the bulk of the large volumes of money involved in stock exchange transactions, is directed to the trading of shares of companies already listed on the stock exchange.