Pop Goes the Bubble? Think Of the Sharemarket As a High Chain Letter.

Listener 9 October, 1999.

Keywords: Business & Finance;

Every time a share is sold, someone else buys it. So the dollars that someone puts into the sharemarket to buy shares equals the amount the ex-shareholders takes out. Suppose there are more people who want to put dollars in than who want to take them out. The potential buyers will have to give an incentive to some shareholders to turn their shares into cash. That inducement is the price of the share going up. So if cash is trying to get into the sharemarket, the prices of shares rise: if cash is trying to get out, they fall. However, in the actual trading the amount of cash that gets in equals the amount that gets out.

Why is the cash trying to get into a share market? Usually it is because the potential buyers think they will get a better return on their money owning shares than in any other investment. Firms pay dividends to shareholders, so hanging onto shares means a flow of dividend receipts over time. Dividends are risky. The amount paid varies from year to year: sometimes it is nothing; sometimes the firm goes bankrupt and never pays another dividend or other cash payments to the shareholders. That is why shareholders expect a higher return than if they invest in fixed interest securities.

A measure of the return on shares is the “price to earnings ratio” – the share price divided by the profits per share (including dividends) of the firm. Currently the P/E (pronounced “P to E”) ratio in the New Zealand share market averages over 20. So the typical share price is twenty-plus times the maximum dividends it could prudently pay. That is an annual return of less than 5 percent. But one can get a safe uninspiring 6.8 percent p.a. or so, by investing in government stock. Why go into a risky investment for a lower return?

Perhaps the business is going to get better. Corporate earnings may not be attractive this year, but next year they might rise, and continue to rise thereafter. The return on government stock is the same each year. But there is a more exciting reason for investing in shares. Every time money pushes into the sharemarket, share prices go up, so shareholders see themselves better off. Those who sell the shares now have more cash. What to do with it? Reinvest it in the sharemarket. With luck share prices will rise again.

So each time a share is sold at a higher price, somebody is paying for it at the higher price. It is like a chain letter. You send $100 to the person at the top of the list of five, strike the name off, added yours to the bottom, and send it to five more people. If everyone kept to the chain, you would eventually get $2500 for the cost of five postage stamps. This cannot go on indefinitely: eventually the scheme will collapse. Some would have made money, but at the expense of those lower on the list. The sharemarket is a little different because of dividends, but the low returns implied by the high P/E ratios suggest people are not in for them.

The jargon for when share prices cannot be sustained by corporate earnings is called a “speculative bubble”. Almost everyone knows the overpricing from expecting further capital gains cannot go on indefinitely, but they are hoping they get to the “top of the chain” before the bubble pops.

Is the New Zealand sharemarket a bubble? The US sharemarket is, and some of its speculative money has flown into New Zealand driving up our share prices, fuelling local greed. When the international bubble bursts, as it surely will one day, New Zealand share prices will fall too – probably dramatically – as everyone tries to cash up, getting their money out of the sharemarket. What happens to the economy? That is another column, which I dont have to write yet. For clues, look at what happened after the 1929 and 1987 crashes.

From Listener 28 August, 1999

Appreciating the Sharemarket

The regular grumblings in the financial pages about the poor performance of the New Zealand share prices in the last decade reflects a longer problem. In a 65 year period, New Zealand share prices rose 30 percent less than production prices: their real capital appreciation was negative. I could not believe it at first, but there it is in the graphs of my In Stormy Seas (Figures 6.6, 16.3) which Americans Phillippe Jordion and William Goetzmann spliced together (I did not). But their study of the world’s sharemarkets shows New Zealand’s share performance is not that different from the average. It the US which is unusual, with an average increase of 4.3 percent a year more than production prices. Once again we learn the danger of treating the US as “normal.”

The poor performance does not mean it is unwise to invest in shares. Tax effects are important, the data does not allow for dividend payments, and alternative investments may be worse. But be cautious. Those who expected to make a sharemarket killing in the low inflation last 1990s have been surprised. They should have looked at the data.