Archives for July 2017

What is the stock market for?

The economic textbooks and the websites of the major stock exchanges proclaim that the key role of a stock market is raising equity capital for businesses wishing to invest and expand. They are the location where those seeking to invest in equity securities can interact with those seeking to issue those same securities. A stock exchange provides this primary market role (trading in new equity securities) within the economy and is enabled to do this by its secondary market role (trading in second-hand equity securities) where the pricing of shares evolves minute-by-minute in response to economic, political and corporate news. New companies to the exchange wishing to sell new shares will find the price of their shares determined with reference to the share prices of other similar companies, and existing companies wishing to sell new shares will find the price of such issues determined by the existing secondary market price.

Thus, in theory, stock exchanges play a pivotal role in capitalism, providing the key market mechanism for the delivery of new equity capital.

Broadly this could be argued to be the case until the TMT bust in 2000-01. Many investors who invested in internet-related new issues during the boom saw 90%+ losses on these shares and confidence in the prospects for new equity issues was lost.

Two other trends emerged at the same time. The first was a shift in investor flows from public equity markets to private equity markets. Thus private equity funds had large cash positions to provide the equity capital for firms wishing to expand, obviating the need to issue shares on the stock market. The second was low inflation, leading to low interest rates and bond yields and consequent strong free cash flows for companies.

A combination of strong free cash flows and owners increasingly focussed on optimally-financed balance sheets at a time of low interest rates meant that in fact companies were seeking to reduce their share count rather than increase their share count through new equity issues.

In recent years however, the primary capital-raising role has all but disappeared as many companies have instigated share-buy-back schemes and barely any companies issue new shares. Even the private equity funds seeking to realise their investments rarely use the stock market for their exits as other private equity funds (with very substantial cash holdings) will buy from them directly.

Stock exchanges thus find themselves left only with their secondary market role. To critics this means a stock market is merely a massive casino in which speculators sell second-hand bits of paper to other speculators and no useful economic purpose is served.

In fact though, the function of the stock exchange has evolved. It has now become the key source of expected long term growth investment returns that enable individuals in a society to save for an extended period of retirement following a working lifetime. Thus the function of stock markets has evolved from the provision of capital to the provision of investment returns on long term savings.

Politically this is hugely significant – the level of the stock market has moved from being of minimal interest to politicians to being a vital factor in the public’s estimation of economic and political success.

The implications of this shift in the key purpose of the stock market are:

  1. Economic policymakers are more likely respond to falls in the stock market, whether or not there is an economic justification for the market decline. The famous quote from Paul Samuelson that “the stock market has forecast 9 of the last 5 recessions” highlights the risk of a policy mistake. There is an inbuilt potential policy error of monetary policy being too easy which at some point creates an inflation problem.
  2. The positive feedback loop between a strong stock market, investor (and hence consumer) confidence and a good economy has taken market valuations to historically very high levels. Following a shock to the system, this feedback loop could easily move into reverse with severe economic consequences.
  3. Demographics matter for analysis of stock market trends. The “baby-boom” generation (born between 1947 and 1962) are now aged between 55 and 70, just completing their peak equity-investing years and moving into the period of their lives when they seek to reduce their equity exposure to fund their retirement lifestyle. This has negative connotations for the valuations of financial assets in the future.