<< Opinions and Analysis

Irrational Exuberance?

March 15 , 2004

Irrational Exuberance - a phrase previously used by Alan Greenspan, Chairman of the US Federal Reserve is now being used by many market participants to describe investor attitudes in Trinidad and Tobago.

There is some evidence to suggest that this is the case and the most recent example of this phenomenon came just last week. Workers at PLIPDECO and its joint venture PLIPWIJS undertook strike action to further their claims for higher wages. As we indicated last week, higher wages that are not accompanied by higher productivity will have a negative impact on a company’s performance.

Were such events to occur in the more developed capital markets of New York or London we would expect to immediately see a fall in the share price with the market recognizing that the information being put out on PLIPDECO was unfavorable to the company’s earnings. Usually the sell sentiment would also carry some “irrational exuberance” providing an opportunity for buyers down the road. This is what accounts for the volatility of share prices over the short term.

On the local market PLIPDECO’s share price appreciated by $2.39 (18.3%) since the beginning of March with a jump of $1.35 last Friday no questions asked. No new information came out to support the upward price movement so one has to assume that the market lacks the ability to rapidly interpret and assimilate information into a company’s share price.

This is the difficulty one faces in attempting to predict the local stock market. As a result it would seem more worthwhile to address the issues currently affecting the market so that investors can make informed decisions.

Right now another sentiment is slowly beginning to creep into the minds of investors. The recent rapid rises in stock prices have been described as a stock market bubble. However a “bubble” only really comes into effect if the market is overvalued. Any attempt to describe the current situation as a “bubble” must at the same time offer some concept of stock market value. Many people mistakenly equate rapid price appreciation with overvaluation.

Fundamental Basis

In 2003 when interest rates began to soften it was expected that corporate earnings would become stronger. To the extent that these earnings also translated into surplus cash flows companies would be in a position to pay higher dividends or seek out acquisitions. Consequently share prices and price earnings (P/E) multiples began to increase and some commentators then put forward the view that as a result of our low interest rate, low inflation environment company valuations should result in higher P/E multiples. Referred to as a structural shift, this argument if true, gives some justification to the higher share prices of the current rally.

Every sector in the stock market has benefited from the low interest rate environment. As a result whether by accident or design the market has a fundamental basis for bidding up the prices of shares. In the financial services sector it is clear that falling interest rates boost the profitability of these companies through at least two separate channels.

First, lower interest rates reduce the cost of funding for financial institutions, especially when the spread between short- and long-term interest rates is wide as was the case when the rate adjustment first took place. Looking forward the steepness of the yield curve is important because finance houses will typically finance themselves by paying short-term interest rates to depositors and charging longer-term rates to borrowers.

Second, lower interest rates improve the creditworthiness of loan customers, be they individuals or corporations. From the perspective of other listed companies even if there is no fundamental improvement in their underlying performance, the ability to service debt improves automatically when borrowing costs fall. This impacts directly on profitability and accounts at least in part for the gains in the market.

Looking Forward

As we move into the second quarter of 2004 we are getting to the stage where the interest rate effect should already be factored into the current share prices. The important consideration now is corporate earnings to determine whether the performance has in fact lived up to expectation. Between now and April 2004 a number of these results should become public.

Once the current economic fundamentals continue into the future corporate earnings should remain strong. However after the round of refinancing and balance sheet restructuring is complete the gains that were associated with these activities cannot now be repeated. As a result the rate of growth in corporate earnings would slow down. Since there is a direct correlation between earnings and share prices the rate of share price appreciation should also slow down.

This is around where we are at now and it is at this pivotal time in the market where if the rate of share price appreciation outpaces the growth in corporate earnings the “bubble” scenario begins to take hold. In such a situation the market becomes increasingly sensitive to changes in interest rates. This is because the market and eventually the economy begin to overheat. Increases in the money supply resulting from increased wages and credit expansion coupled with the “wealth effect” as investors net worth increases starts to fuel an inflationary trend. The Governor of the Central Bank has already alluded to the risk of inflation rising above the 4-5% mark. Further the Central Bank has also indicated that pressure is being placed on our foreign currency reserves by borrowings from the wider Caribbean. These comments all other things being equal, give a hint that an upward interest rate adjustment is in the offering some where down the road.

Investors should be very aware that if they have accepted the earlier assertion whether implicitly or otherwise that a low interest, low inflation environment give rise to shares trading at higher P/E multiples they also have to content with the reverse (correction) when the fundamentals of inflation and / or interest rates begin to move upward. Under this scenario the further you move into the “bubble” the bigger the correction that needs to take place.

Note well that all companies will not be affected in the same way. Companies that utilized the low interest rate environment to effect expansion that leads to sustainable growth will move to and stay at a higher P/E multiple. Companies where the growth is not sustainable will eventually see corrections to their share price. The wise investor should therefore seek out those companies that have managed to achieve sustainable growth as these will be the ones most capable of continued success when economic fundamentals change.

Ian Narine is the General Manager at West Indies Stockbrokers Limited. He can be contacted at iann@wisett.com

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TRADING DATE: 2011-06-02
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Agostini's Ltd	-	11.25	-
Angostura	1,000	9.50	-
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ANSA Merchant	46	31.80	-
BCBTT	-	11.90	-
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