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International Capital Markets Published by the International Monetary Fund D. Equity MarketsEquity prices in industrial countries have risen strongly over the past 18 months (Figures 8-9), with the increase in Japanese prices being somewhat less pronounced. Markets in 10 European countries ended 1996 at all time highs, while North American, French, and German markets also reached record valuations in December. In local currencies, European markets comfortably outperformed the 20 percent advance in U.S. equity prices in 1996. Some of the momentum in European equity markets has been attributed to improved prospects for the export sectors in these economies that is associated with the depreciation of most continental European currencies against the dollar. Also favorable has been the trend toward low interest rates, which have an important impact on the discounted value of future corporate earnings.
The U.S. equity market has clearly been the star performer in the 1990s (Figure 8). Although the rise in U.S. markets since early 1996 has been matched or exceeded by other advanced equity markets, U.S. markets have outperformed most other advanced equity markets since the beginning of the decade, in some cases by a factor of two or more. Remarkably, in the period 1992-96, the Dow Jones Industrial Average doubled in value, while historically the index has doubled every 17 years. Moreover, over the same period, U.S. equity market capitalization increased from 72 percent of GDP to 107 percent of GDP. An important factor that has added significant momentum to U.S. equity prices during the past few years is the persistence of large inflows into U.S. equity mutual funds. During January 1995-April 1997, U.S. equity mutual funds were the recipients of $424 billion in new investments, and they currently manage $1.8 trillion. Mutual funds control 20 percent of the U.S. equity market capitalization, and they have a significant impact on prices, especially because they channel the bulk of new flows into U.S. equity markets. Although improved profits helps explain the rise in U.S. markets, price gains of the magnitude experienced in recent years have pushed some of the conventional valuation indicators into territory that has raised concerns of overvaluation (Figure 10). Dividend yields—currently at about 2 percent—have fallen to historic lows and are about half their long-term average, and both the market-price-to-book ratio and the closely related Tobin's q-ratio are deviating from their historical ranges. While these deviations can be explained by the shift away from capital intensive industries to services, the rise in the ratio of equity prices to book value is still extraordinary. Moreover, the average price-earnings ratio is clearly approaching the upper end of its normal range. On the other hand, given the favorable interest rate environment, the equity-yield gap, which measures the difference between long-term bond yields and the inverse of the P/E ratio, remains within historic ranges and is still well below the levels reached prior to the 1987 stock market crash.
In assessing the sustainability of U.S. equity prices, a key question is whether U.S. equity valuations reflect expectations of further increases in earnings growth that may prove unrealistic.10 In early 1997, S&P 500 earnings were about 15 percent above a year earlier, and a majority of companies' earnings exceeded market forecasts. Earnings growth averaged about 15 percent during the past five years, while average 5-year real earnings growth since 1960 has been in the range of 2 percent. This suggests that the balance of risks would imply lower rather than higher earnings growth, especially because profit margins would be unlikely to improve in an environment of near-capacity economic activity and tight labor markets. Despite these downside risks, U.S. equities do not appear to be as far out of line as they were in August 1987 or when compared to the Japanese market in 1989, when bond yields were high and rising, corporate earnings were weak, and monetary policy was stimulative. Nevertheless, equity prices are at levels that make them vulnerable to reductions in corporate earnings and to increases in interest rates. An additional concern is that the steady, high returns experienced in recent years might have created the illusion for small mutual-fund investors that there are only limited risks associated with equity investments. It remains to be seen, therefore, how small investors (and the mutual funds they invest in) will behave in a more volatile environment in which equity investments are seen to be risky and to produce less spectacular gains.11 The Japanese market has not performed as strongly as markets in some of the other main industrial countries (Table 8).12 Japan's Nikkei 225 index declined 2.5 percent in 1996. There is little domestic demand for Japanese equities. Some major institutional investors (e.g., insurance companies) have negative cash flows, while others, such as banks, have weak balance sheets, and both groups have been forced to sell equities. Households also have been net sellers of domestic equities. Prior to the collapse of equity prices in 1990, investment trusts had more than half of their assets invested in Japanese equities; by the first quarter of 1997, this weighting was just over 20 percent. While this smaller weighting can be traced to lower equity prices, there also have been significant net redemptions in recent years. Public and foreign purchases have provided some support for Japanese equity prices. Continuing concerns about the nonperforming loan problem led bank stocks to under- perform the market as a whole: between January 1996 and May 1997, the TOPIX index recorded a drop of about 10 percent, whereas the TOPIX bank index fell nearly 30 percent.
A significant rebound in Japanese equity prices rests, therefore, on the resolution of several sources of uncertainty about the Japanese economy and the state of the financial system. The broader market is likely to be held back by weakness in financial sector equities and the weak local investor demand for equities. A resolution of the financial system problems in Japan would have significant benefits in terms of resolving uncertainty about the prospects for the Japanese economy, and would help in reviving investor demand. 10This was emphasized by Federal Reserve Board Chairman Greenspan in remarks before a meeting of the National Association of Business Economists on March 5, 1997 (as reported by Bloomberg Financial Markets). 12Sharpe ratios indicate that Japanese equities have underperformed equities in the other G-7 countries and the return on riskless yen assets. |
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