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Rod Oram: Stock markets skip reality

Even though soaring stock markets are an imperfect guide to the economic health of nations, particularly in these pandemic times, they still tell us important things about themselves and those economies, says Rod Oram

First, stock markets are increasingly unrepresentative of the breadth of activity in economies. Only 1 percent of US companies are listed on US markets. Those that are listed account for barely one-third of employment. The New Zealand market is even less representative with, for example, the primary sector barely represented even though it accounts for some 15 percent of GDP.

But despite the pandemic’s deep damage and stresses to economies, stock markets are soaring because investors are pouring increasing sums into them. This strongly reflects a lack of attractive alternatives. For example, rock bottom interest rates mean bonds offer low yields and no scope for capital growth. Fear of missing out on the equity boom is another driver for many investors.

As a result, some stock markets have become extraordinarily large relative to the size of their economies. Those in the US, for example, are now worth close to an equivalent of 200 percent of US GDP. Back in 1990 they were equivalent to only 60 percent of GDP, rising to 120 percent in 1996.

A word of caution about the data. GDP measures the value of a flow of economic activity; whereas share prices measure the value of a stock of capital. While they aren’t strictly comparable, they are still a guide to trends. For example, Japan’s stock markets hit a valuation of 140 percent of GDP in 1989. That was at the peak of its asset bubble, which was notoriously underpinned by many deeply troubled companies. When investors finally acknowledged the nation's dire economic reality, many of those companies collapsed and the market crashed too.

The total valuation of companies listed on the NZX reached $165 billion at the end of August, equal to only 55 percent of our GDP. But that low comparison reflects how unrepresentative the market is of the economy. There is still plenty of scope in today’s high valuations for some companies to disappoint their shareholders with seriously inadequate profits and for some high fliers to crash.

Second, the changing constituents of stock market indices tell us a lot about the changing nature of economies. For example, the Dow Jones Industrial Average of 30 companies recently dropped ExxonMobil (oil), Pfizer (pharmaceuticals) and Raytheon (aerospace and defence); and added Salesforce (cloud computing), Amgen (biotechnology) and Honeywell (aerospace and industrial manufacturer).

ExxonMobil, then known as Standard Oil New Jersey, joined the Dow in 1928. Its fortunes soared for almost a century. But in 2013, it lost the title as the most valuable company listed on global stock markets to Apple, which has since held top spot apart from conceding it to Microsoft on a few brief occasions. Currently Apple’s market cap is US$2.03 trillion and Exxon’s is US$160b.

Exxon is still the largest oil company in the world by stock market capitalisation, if Saudi Aramco is excluded because only a sliver of its capital is listed. But total oil and gas companies constitute only 2.3 percent of the market cap of the S&P 500 index, down from 15 percent in 2008. Investors who have stuck with fossil fuel companies have underperformed the market.

The market cap of the five largest tech stocks in the S&P 500 - Alphabet (the parent of Google), Amazon, Apple, Facebook and Microsoft – is greater than that of the 76 oil and gas companies in the index. Indeed, the US$8 trillion value of the five combined accounts for 25 percent of the market cap of the index, with the other 500 companies (confusingly, there are 505 in it) accounting for the other 75 percent.

Tech valuations have soared in a surprisingly short time. Apple was founded in 1976 and floated on the stock market in 1980. But it didn’t reach its first US$1 tr in market cap until 2018; all of its second trillion came in just 21 weeks to mid-August; than it added another third of a trillion in the next two and a half weeks before the brief tech correction in this past week.

In those heady 21 weeks, Apple’s market cap grew on average per day by US$6.8b, which was more than the entire market cap of American Airlines.

Apple hasn’t delivered much product innovation in the past two years. But it has got really good at delivering profits, particularly during the pandemic. For the three months to June 30 its net profits were US$11.2b, up 12 per cent on a year earlier. It increased sales on every product in every part of the world, even though most of its retail stores were closed.

These enormous “Nasdaq whale” bets have been described as “dangerous” by some market participants and have clearly heightened the feverish market activity ...

The shares of the top five US tech companies are trading on 44 times their forecast earnings for this year.

In contrast, Tesla’s shares have performed even more spectacularly but without robust earnings or scale of business to underpin it. Its share price rocketed from US$85 in March to US$498 at the end of August. It has since fallen back to US$330 but its price/earnings ratio is still almost 1000.

Even with this sharp correction in share price, Tesla’s market cap is still US$40b larger than that of Toyota’s and Volkswagen’s combined, yet they are the world’s two largest car manufacturers.

One factor in Tesla’s off the charts stock market performance is the role SoftBank, the Japanese venture fund run by Masayoshi Son, has been playing in the markets. In recent weeks it has been buying billions of dollars’ worth of equity derivatives in a range of tech stocks including Tesla.

These enormous “Nasdaq whale” bets have been described as “dangerous” by some market participants and have clearly heightened the feverish market activity, the Financial Times reported when it broke the story last week.

Further evidence of the increasingly speculative nature of the tech bubble is the proliferation of companies trading on a multiple of more than 10 times sales. Bloomberg data shows more than 530 out of America’s 8,513 listed common stocks are in that category. That’s 6.2 percent of all common stocks, up from a ratio of 3.8 percent at the market’s low in March. By comparison, at the absolute peak of the dotcom bubble in March 2000 6.6 percent of stocks traded above 10 times sales.

As Andrew Parlin, a fund manager noted in his recent article in the FT: “In 2000, three of the top 10 US stocks by market capitalisation had price-to-sales ratios over 10 times: Cisco, Intel and Oracle. Today, four of the top 10 US stocks have price-to-sales ratios over 10 times: Microsoft, Facebook, Tesla and Visa.”

Moreover, “if a stock trading on 10 times sales earns net profit margins of 20 percent — a very high margin indeed — its price-to-earnings ratio is an extremely expensive 50 times.”

So, detachment from reality is perhaps the most important thing stock markets are telling us about themselves.

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