Emerald Group Publishing Limited
Copyright © 2000, MCB UP Limited
A sign of the times
Just possibly you may have noticed that stockmarkets have been a touch volatile of late. Implied volatility the number that option sellers plug into their option price has jumped to levels last seen in 1987. And the indices disguise how bad things are for many stocks. For some high-tech stocks, implied volatility has been as high as 100 per cent. The answer to the question as to why stocks have become so volatile has important implications for companies' balance sheets.
For luddites like me, it is tempting to say that the markets have become more volatile because all manner of high-techery had been bid up to levels that made Japan's stockmarket bubble of the late 1980s look positively tame. Overall volatility has risen partly because investors have been heading for the exit in such stocks, and partly because they have been buying back shares in companies that heaven forbid make money. This reweighting in such a short period is bound to increase volatility.
Well, that explanation, tempting though it is, won't do. It might explain why stocks that were a triumph of hype over experience have become amazingly volatile; it might explain why volatility has increased for shares in companies that have been around for more than five years. But it does not explain why smaller "old economy firms" have become as volatile as the newest thing. For that, another explanation is needed.
Even if, like me, you do not think that the Internet is a greater innovation than trains, the lightbulb and the car combined, it is still a pretty dramatic transformation in the way in which companies are able to do business. And it is also happening much quicker than previous technological revolutions.
Why does this matter? Because no one knows what the effects will be on existing companies, nor who will emerge as a winner when the dust settles. Will traditional banks, lumbered with all their legacy systems, have all their customers pinched by Web upstarts? Will business-to-business or business-to-consumer exchanges eat into companies' margins and destroy the middle man? Nobody knows. And because nobody knows, markets have become more volatile: volatility is a measure of that risk. But more volatile stocks have huge implications for how firms finance themselves. Bond holders like certainty. Even if a firm does well they get little upside; but if they do badly, there is a lot of downside. So they like stable, predictable cashflows because they are, in effect, selling a put option on the value of a firm. As firms' outlook becomes less stable as reflected in the volatility of a firm's share price so the value of that option rises. In other words, they will demand a higher yield to buy firms' bonds.
Another thing has been going on as well: many companies, especially old-economy companies, have been buying back their shares with debt. Equity investors, after all, are concerned mainly with earnings per share. Better therefore to become more leveraged. Over the past two years, non-financial firms have increased their debts by US$900 billion and bought back US$460 billion of equity. In the year to last September, the debts of non-financial firms increased by a dizzy 12 per cent. Bond holders take exception to such things.
All of which helps to explain why corporate bonds have performed so dismally of late, especially in America. So even though current default rates are still minimal, spreads over Treasuries on investment-grade bonds are now higher than junk-bond spreads at the height of the financial crisis that followed Russia's default. To put that in some sort of perspective, David Goldman of CSFB points out that single-A spreads of 170 basis points over Treasuries implies that the market expects a default rate more than ten times greater than in the Great Depression. In a few old economy sectors, spreads are over 1,000 basis points. Clearly, markets expect few of these companies to be in business in a few years time. Such is the shock of the new.
If such expectations seem a little foolish, that is because they are. Not all old-economy companies are run by neanderthals. And if companies do not benefit from the Internet revolution, what is the point of it all? Still, such spreads leave many firms with a dilemma. Of late their shares have been eschewed by investors, making equity much more expensive to raise. (How many companies now wish that they had raised more of the stuff before markets' infatuation with all things new sent their shares into a tailspin?) Now debt is also much dearer than it was, too.
Such is the glowing state of America's and, increasingly, Europe's economy, that they can finance themselves partly out of cashflow. But what would happen if America's economy stopped growing at its present rate, or (perish the thought) even had a recession? A sharp fall in the stockmarket is clearly one mechanism by which this might happen. The wealth effect in America is substantial. Private-sector savings are at a record low. Rebuilding their finances by saving more might make a recession much longer and deeper than most people expect as Japan showed for much of the last decade. In such circumstances one would assume that companies would have to try and reduce the debts that they have so carelessly built up in the past few years. That will not be a pleasant sight.
Richard Cookson is banking and markets editor for The Economist. Previously he wrote for Risk magazine.