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24 July 2006 Does the share market really matter?Australia has about the highest recorded level of per capita participation in the share market in the world; a majority (55 per cent) of adult Australians own shares, either directly (44 per cent) or indirectly (Australian Stock Exchange 2005). Fluctuations in the value of oft-cited indices of market performance, the S&P/ASX200 and the S&P/All Ordinaries, will naturally be a matter of concern to these investors because share prices reflect estimates of future profits. Perhaps everyone, not just investors, should follow the twisting fortunes of the market because they also foreshadow what’s in store for the real economy. As it happens, the theory and evidence on the association between changes in share market prices and the economy do not support such an inference. There are at least three reasons why there is not a strong association between share market prices and economic growth: competition, market efficiency or rather inefficiency, and alternative sources of capital. Competition
Warren Buffet, who has a good claim to be the world’s most successful investor, has famously quipped that he likes to think that if he had been at Kitty Hawk in 1903 when Orville Wright took off he would have been farsighted enough, and public-spirited enough, to shoot him down because of the cumulative losses suffered by investors who’ve bought shares in the airline industry since its beginnings. Buffet was, one presumes, just kidding since the airline industry has benefited the economy enormously. Indeed the International Air Transport Association in its economic briefing for February 2006, estimates that the value added by the global airline industry, measured as the difference between the cost and value of its services was, in 2004 alone, US$140 to US$145 billion in direct benefits and around US$2,960 billion in direct and indirect benefits (2006, p. 1). However, consumers, employees and other suppliers captured all the net benefits generated by the airline industry. Shareholders across all airlines made a loss of US$4.2 billion, which illustrates the point of Buffet’s quip. Advances in technology do not benefit shareholders unless their companies have lasting monopolies, a condition rarer than most people presume. Intense competition in the airline industry has resulted in poor returns to shareholders. One might consider the airline industry a special case because of the enormous subsidies it receives from governments keen to have a national flag-bearer in the sky. The Chinese economy, however, provides a compelling illustration that economic growth does not invariably go hand-in-hand with an upward trend in share prices. Jeremy Siegel, professor of finance at the Wharton School of Business, is one of many commentators who has observed the curious fact that although the Chinese economy easily outpaced any other in the world over the twelve years to 2005, its share markets have been about the worst; ‘turning a $1,000 investment into a little over $300’. A report in the Australian Financial Review (10 January 2006) revealed the answer:
Economic growth, no doubt, is great for China but it hasn’t delivered anything like a windfall to those share market investors who got in early at the beginning of the country’s long boom in its real economy. For shareholders to benefit from economic growth, their companies must capture the gains from growth. If the benefits of the increases in expenditure and improvements in technology that fuel economic growth are captured by new companies entering the field or by consumers in the form of lower prices, existing shareholders will not experience an increase in share returns.
Egregiously poor corporate governance, one is constantly reminded via the press, plagues the Chinese economy and so it is plausible that the abysmal performance of the Chinese share market reflects the lack of protection of shareholder rights. I’ll return to this issue later, but the problem with blaming poor corporate governance is that the Chinese experience is far from unique. Jay Ritter, an eminent financial economist, has investigated the relationship between real returns to shares and real per capita GDP for 16 countries, over the 20th century (2005). He estimates the share markets in these sixteen countries together represent around 90 per cent of the value of all public companies in the world. He finds that, contrary to expectation, higher economic growth is associated with lower share market returns. A comparison of two of the sixteen countries helps illustrate the point. Over the years 1900 through to 2002, Australia’s annual real return to equity (adjusted for dividends and events such as stock splits) was around 7.3 per cent while annual growth in real per capita GDP was just over 1.5 per cent. Over the same period, Japan’s annual growth in per capita GDP was much higher at just under 3 per cent but its annual real return to equity averaged just 4.1 per cent. As Ritter observes, while theory suggests a lack of correlation between economic growth and share returns, it is surprising that the relationship should be negative. Market inefficiencyOne explanation Ritter posits for this unexpected finding is that the market might be inefficient. An efficient share market is one where share prices reflect the value of future profits rapidly and without bias. One implication of an inefficient market is that even if economic growth feeds directly into profits, share prices will not accurately reflect this relationship and so there is little point in looking to share price changes for indications of changes in economic growth. So just how efficient are share markets? In 1978, Michael Jensen, then and now an eminent economist declared that ‘there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Markets Hypothesis’ (p. 95). Jensen made his declaration in the editorial preface to a special edition of the Journal of Financial Economics devoted to research documenting evidence challenging market efficiency. Jensen’s editorial was, in hindsight, the high-water mark of the influence of the efficient market hypothesis. By 2004, Jensen’s own views on the EMH and those of other financial economists had been revised so significantly that his article on the dangers of overvalued shares won the best paper award in European Financial Management in that year.
Share prices may be inefficient (by, say, over- or under-reacting to information), but they might still affect the real economy by influencing the rate of investment in different sectors of the economy. Prominent financial economists Randall Morck, Andrei Shleifer and Robert Vishny directly investigated this issue, prompted in part by the fact that the share market crash of 1987 did not trigger a correspondingly large investment collapse. Their findings, reported in an article tellingly titled ‘The stock market and investment: Is the market a sideshow?’, lead them to conclude that ‘[o]verall, a fair reading of the evidence is that the stock market is a sometimes faulty predictor of the future, which does not receive much attention [from managers when they predict business conditions] and does not influence aggregate investment’ (Morck et al. 1990, p. 200). There is an important qualification to the view that the share market does not influence real investment. Morck and his colleagues, have noted that the incidence of initial public offerings (that is, the first-time sale of shares to the public by companies) increases in periods when share returns are high. Existing companies are also more likely to raise more finance by issuing further shares to public in boom times. However, it seems that this raising of funds has less to do with the share market meeting a real funding need than with managers taking advantage of periods when their shares are over-valued to raise cheap capital. This raises a question: is the new capital being used to finance good projects that would otherwise not get off the ground, or is it being used for ‘empire building’? The latter is certainly attractive to managers, given that CEO and directors’ pay is most closely associated with firm size than any other measure. Further, one of the most extensively researched phenomena in finance is the subsequent negative share market performance of companies that issue shares to the public. This is, of course, exactly what one would expect if managers time the sale of shares to coincide with periods when they are over-valued. Alternative sources of capital
Notwithstanding these problems, one could argue that although share markets might be inefficient, they provide an important—not to say vital—source of finance to companies. In fact, share markets are far from being important as a source of finance. Franklin Allen, a former president of the American Finance Association, has noted in his paper, Comparative Financial Systems: A Survey (co-authored with long-time collaborator, Douglas Gale) that internal finance (that is, profit from existing operations of companies that is not distributed as dividends to shareholders) is the most important source of investment funding in all countries. For instance, in the United States, internal finance accounts for around 91 per cent of investment funding while in the United Kingdom it accounts for 97.3 per cent. As Franklin and Gale observe:
Share markets, then, fund only a small proportion of investments. But their unimportance also shows up in other ways. Economic development and growth more generally are only weakly, if at all, related to the development of the share market per se. China provides a prominent example. Economists Franklin Allen, Jun Qian and Meijun Qian (2005) point out that while China has one of the fastest growing economies in the world that is on track to overtake the United States and become the largest economy within ten years, the finance behind China’s economic growth has come principally from the private sector operating outside the share market. ImplicationsThese findings run counter to widely held notions about the share market, which might lead us to question their credibility. However, all the studies I’ve cited include at least one eminent financial economist with impeccable credentials. Franklin Allen, for example, is a former president of the American Finance Association, Andrei Shleifer is a winner of the John Bates Clark medal, awarded every second year to the best economist under the age of forty, and Jay Ritter is one of the most often cited authors in finance with a prolific record of publications in top-rank journals. And although these financial economists may question the relative importance of the share market, they are firmly in favour of markets in general as effective mechanisms for channelling resources to their most productive use. A specific example illustrates the difference: the stock market may not be all that significant in explaining China’s economic growth but the reasons for China’s success are undoubtedly related to the unleashing of market forces. Indeed, Allen, Qian and Qian argue that among Chinese firms an ‘important mechanism that drives good management and corporate governance is competition. Given the environment of low survivorship during early stages of a firm’s development, firms have a strong incentive to gain a competitive advantage’ (2005. p. 60).
The argument that the share market is far from an essential component of the economy gives rise to another puzzle. Why does it loom so large in many modern economies and not in others? The likely answer is that the share market, far from being the purest expression of ‘free market’ principles, is an institution the viability of which is highly dependent on the development of an elaborate regulatory and enforcement regime that determines the rights of participants and establishes strict procedures for trade. For instance, acquiring control of a company by purchasing a majority of its issued shares is not, as one might imagine, a simple process of making an appropriately priced offer for the requisite number of shares. Rather, it entails an elaborate and expensive process in which the party seeking control must furnish detailed information to existing shareholders about their plans for the company, give them sufficient time to consider the offer, and equal opportunity to benefit from the offer. Even if an investor is not seeking control but merely intending to purchase a parcel of shares, the investor has to be sure that he or she is not trading on the basis of privileged information unknown to the rest of the market. The point here is not that the often exquisite rules of trade on the share market are unduly complex (although that may be true) but rather that the degree of trading that takes place on the share market, and the type of investor who participates in trading, depend on the degree of regulatory protection investors receive. As prominent law and economics scholar, Bernard Black, has noted,
So the share market looms large in some vibrant economies and not in others because some countries, such as the United States and Australia, go much further than other countries, such as Japan and Germany, in protecting the rights of minority investors. Markets with good protection of minority investors are much larger than markets without, where share market size is expressed as a percentage of GDP. The curious irony of course is that while the prevailing orthodoxy in the United States and Australia is that suppliers of capital need to be protected by an elaborate regulatory system in order to ensure their participation in the share market, the opposite view seems to hold in the labour market where it is argued that minimal labour laws are optimal. ReferencesAllen, F. & Gale, D. 2001, ‘Comparative financial systems: A survey’ [Online], Available: http://fic.wharton.upenn.edu/fic/papers/01/0115.pdf [2006, 20 Jul]. Allen, F., Qian, J. & Qian, M. 2005, ‘Law, finance, and economic growth in China’, Journal of Financial Economics, vol. 77, no. 1, pp. 57–116. Australian Stock Exchange 2005, 2004 Australian Share Ownership Study, Australian Stock Exchange, Sydney [Online], Available: http://www.asx.com.au/resources/newsletters/investor_update/20050308 [2006, 20 Jul]. Black, B. 2000, ‘The core institutions that support strong securities markets’, Business Lawyer, vol. 55, no. 4, pp. 1565–1607. International Air Transport Association 2006, The value added by airlines, Economics Briefing, February. Jensen, M. 1978, ‘Some anomalous evidence regarding market efficiency’, Journal of Financial Economics, vol. 6, no. 2/3, pp. 95–101. Morck, R., Shleifer, A., Vishny, R. W., Shapiro, M. & Poterba, J. M. 1990, ‘The stock market and investment: Is the market a sideshow?’ Brookings Papers on Economic Activity, vol. 1990 no. pp. 157–215. Ritter, J. R., 2005, ‘Economic growth and equity returns’, Pacific-Basin Finance Journal, vol. 13, no. 1, pp. 489–503. Ryan, C., 2006, ‘Concern over world factory’s flaws’, Australian Financial Review, 10 January. Siegel, J. 2005, ‘Move over U.S.A’, The Future for Investors [Online] Available: http://finance.yahoo.com/columnist/article/futureinvest/986?p=1 [2006, 20 Jul]. Associate Professor Raymond da Silva Rosa is Director, WA Centre for Capital Markets Research at UWA Business School at the University of Western Australia. View other articles by Raymond da Silva Rosa:
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