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.
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