Looking for trouble

American shares

Apr 21st 2005
From The Economist print edition

The American stockmarket has taken a tumble. Why are investors so jittery?

LIKE a mob of meerkats alert to any approaching danger, investors in American shares take fright easily these days. Spooked by mixed economic and company news last week, they fled stocks for bonds, pushing down the big share-price indices to their lowest in five months and dragging markets in Europe and Japan with them (see chart below). Spirits revived a bit this week, despite the first-quarter loss of $1.1 billion announced by General Motors on April 19th. But the little creatures turned tail again the next day, when unexpectedly high inflation and low fuel supplies sent share and bond prices down and oil prices up. Are investors right to be so nervous?

It is true that the domestic economic news is beginning to point to an unhappy combination of lower growth and higher inflation. Four big sets of statistics for March—employment, retail sales, manufacturing production and housing starts—suggest that the American economy is losing momentum. This week's inflation data were surprisingly bad: consumer prices rose by 0.6% in March alone; the core index (which excludes volatile food and fuel prices) rose by 0.4%. Core inflation in the first three months of the year was 3.3% at an annualised rate, well above the Federal Reserve's comfort zone. Some now think that the Fed may speed up its recent step-by-step increases in interest rates.

This adds to the stockmarket's fear that the American consumer, on whose shoulders the world's economic growth now rests, is buckling as interest rates and oil prices rise. A weaker housing market could complete the consumer's undoing: prices have climbed by 65% across the nation since 1997 and by much more in some areas, and the boom has helped to fuel an increase in household debt and consumption. A reported drop of almost four points to 88.7 in the University of Michigan's April consumer-sentiment index added to this week's chill. Amid talk of “stagflation”, the S&P 500 share index headed down again, closing on April 20th at 1,137.5, 4.2% lower than on April 12th, when the most recent slide began, and 6.1% lower than at the start of the year.

Against this background, first-quarter corporate earnings have not been especially solid. There are plenty of stars—Apple, Yahoo!, Intel, Caterpillar, General Electric, Bank of America, Wachovia—but plenty of weak spots too—not least IBM, whose disappointing earnings gave investors the jitters last week, Coca-Cola and virtually anything that moves (General Motors, Ford, Continental Airlines). Though lower than last year's, forecasts of growth in corporate profits in 2005 have increased since the year began, according to Thomson First Call, a research firm that tabulates brokers' estimates. In that, however, they seem not to reflect investors' sentiments.

Three well-known measures of investor confidence now indicate a sharp reversal of mood. In March, of the 324 global fund managers (with more than $1 trillion in assets among them) that Merrill Lynch surveys each month, 11% more believed that economic growth would increase than that it would decrease. In April, their views were the opposite: 20% more thought that growth would fall than that it would rise. The survey found a similar shift in beliefs about an increase in corporate profits, and the fund managers' assumption of higher inflation continued. An index compiled by State Street Global Markets shows that investors are reallocating assets away from the riskier ones, in expectation of hard times to come.

Jumping at shadows

All this nervousness might look a little odd. After all, corporate America has emerged from the dark days of 2000-02 with increased productivity, strengthened balance sheets and mostly huge profits. The economic news is not catastrophic, merely intermittently depressing. So why this rumbling unease that reveals itself whenever a fact or figure disconcerts?

One possible answer comes from Rochdale Research, part of a boutique broker-dealer in New York. Nicholas Colas, head of research there, suggests that firms have achieved their strong balance sheets and impressive cash balances (at non-financial firms in the S&P 500, equal to 14% of total assets at the end of 2004) by underinvesting in their operations, despite the good global growth of recent years. They have tended to their financial ratios and paid out huge dollops of cash to shareholders through dividends, special repayments (Microsoft) and share repurchases (Citigroup, Merrill Lynch, Dell, and many others in the S&P 500). What they have not done is place bold bets on their own future growth, despite a recent uptick in mergers and acquisitions in which private-equity firms make much of the running. Since companies have done little to generate growth internally, they are unusually dependent on macroeconomic trends for it.

This makes sense. As the chart above shows, American firms are taking in more cash than they know what to do with. The return on non-financial S&P firms' capital employed has been rising, reflecting healthy profitability; the rate of growth of capital employed, having dropped sharply in 2002-03, has picked up only slightly, reflecting the reluctance to invest.

In part, this is a function of size. The bigger a company gets, the harder it is to manage what it has, still less to come up with something new. Citigroup is in divesting mode (it announced the sale of its Travelers life-insurance business to MetLife in January), at least for the moment. Microsoft, though energetic, has not found a way to compensate for what seems to be the natural diminution of its business through the growth of open-source software and computing alternatives to the PC.

In part it is also a function of a shift in corporate power in America to stronger, mainly institutional, shareholders from chief executives weakened by a climate of muddle and outright scandal. There is no harm in a company returning to shareholders cash for which it has no profitable use: that is what responsible stewardship would dictate. But it is also possible that powerful shareholders' own short-termism influences the decision: it is harder to estimate the eventual long-run profits from business expansion than it is to see the immediate gap between the return on shares (3.3% total trailing annual return for the S&P 500 as a whole) and the lower reward available on the cash it takes to buy them back.

And what of other stockmarkets, wrestling—especially in continental Europe and Japan—with their own economic demons as well as with America's? Markets in Britain, France and Germany all fell this week, though the British and French indices are still higher than at the start of the year. On April 20th, Japan's Nikkei rose, heartened by Intel's strong performance, before falling again on America's renewed gloom. It is all in the eye of the beholder.

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