Gaynor: Our market insulated from collapse

The big issue this week was the poor performance of world sharemarkets and what impact, if any, they would have on the domestic market. This is difficult to predict, but on a first appraisal our market should be relatively immune from a serious downturn in international equities.

There is no doubt that United States stockmarkets, particularly the Nasdaq, were gripped by a wild speculative bubble over the past few years, and the US economy is beginning to pay the price.

At first there was a cautious attitude towards the internet and IT boom but most investors eventually jumped on board.

In December 1996 - when the Nasdaq Composite Index was just 1300 and the Dow Jones Industrial Average 6400 - Alan Greenspan, chairman of the Federal Reserve Board, accused investors of irrational exuberance.

Seven months later, Dr Greenspan began to talk about a new era. This came to describe a US economy with huge technology-driven productivity gains and uninterrupted growth.

The share price boom also gained credibility because it coincided with the ascendancy of the efficient market theorists. Proponents of this theory believe investors act rationally and share prices reflect the considered judgment of each individual. A speculative boom cannot occur in this rational environment.

But a speculative boom did occur in the United States. It distorted investment decisions and created imbalances in the economy. Too much money was invested in companies that will never earn a profit. Consumers overspent and over-borrowed. Savings rates plunged.

These problems are now having a big impact on the American economy and its stockmarkets.

The IT sector has contributed 20 to 33 per cent of US economic growth over the past five years, and a downturn in this sector is now spreading rapidly through the economy. Some veteran executives are saying it is the sharpest downturn they have ever experienced.

Most economists have written off 2001, but are looking to a year-end recovery and a stronger 2002.

At first the sharemarket carnage was confined to the technology-dominated Nasdaq, which has fallen 62 per cent from a peak of 5133 on March 10 last year to 1941 on Thursday.

The market's pin-up company, Amazon.com, has plunged from $113 in December 1999 to $10.87 a share.

In recent weeks, the downturn has shifted to the broader market and the benchmark Dow Jones Industrial Average has fallen from 11,719 in January 1999 to close at 10,031 on Thursday.

North American analysts have been frantically reducing their earnings forecasts since the beginning of the year. They are particularly bearish on technology stock and banks, the latter because they are overpriced and exposed to high levels of consumer and company debt.

The most important feature of US profit forecasts is that analysts are much more bullish about 2002. All but two of the 30 companies in the Dow Jones Industrial Average are expected to have higher earnings next year.

In other words analysts are expecting a V-curve recovery instead of a U-curve upturn or a L-curve recession. (A V-curve downturn is a sharp fall in economic activity followed by a quick recovery whereas U and L-curve recessions are more sustained.)

The keys to the US economy and sharemarkets are President Bush's tax cuts and Dr Greenspan's interest rates reductions. If they revive the ailing economy then 2002 earning forecasts can be achieved and the Wall Street and Nasdaq markets should recover this year.

If the recession is a U-shaped curve or worse then the pain and suffering on US stockmarkets will continue.

The New Zealand sharemarket, with few technology companies and no banks, has had no recent irrational exuberance. There has also been a switch in emphasis on overseas markets from growth-orientated companies to value stocks, a development that helps our market.

On the other hand, a recession in the United States and Australia will have a negative impact on our overseas trade because a third of our exports go to these two countries.

As the US and Australian economies slow, their companies will face reduced demand and will aggressively compete with New Zealand exports on international markets.

In its March quarterly predictions, the Institute of Economic Research expects export conditions to weaken. It says: "Export growth will ease as the US and Australia slow and the New Zealand dollar appreciates. Agriculture production will start to decline toward the end of the year following lower commodity prices.

"Meanwhile, the domestic sector will strengthen as this year's higher agricultural export earnings are spent."

In other words, the institute expects the economy to remain reasonably strong because the domestic sector will replace exports as the main driver of growth.

As the US economy recovers, export growth is expected to pick up again with tourism leading the way.

Like most other forecasters, the institute is betting on a V-shape recession in the United States rather than a U or L-curve downturn.

Sharemarket analysts in this country have been taking a more cautious view, particularly of the current year.

Company results for the period ending December 31 were slightly worse than expected. Analysts have downgraded three profit forecasts for every one upgraded over the past few weeks.

The key to our sharemarket performance will be earnings, earnings, and earnings.

If the US contraction is V-curved and our export markets remain reasonably firm then the outlook is quite positive.

If the US goes into a sharp and prolonged downturn and takes the rest of the world with it then the prospects are less enticing.

In the latter scenario our sharemarket should be less adversely affected than others because of its lower price/earnings multiples.

The average prospective p/e of the largest New Zealand companies is 18, compared with 22 for the companies in the Dow Jones Industrial Average. If the p/e is weighted to market value, then the DJIA is much higher because its three largest companies have a 2001 p/e between 18 and 30 whereas our top three are between 12 and 17.

One group to look at is the high p/e stocks that are certain to maintain their strong earnings growth. The standout company in this area is The Warehouse, which will not suffer from a shift from export to domestic-driven economic growth. The discount retailer is now New Zealand's fifth-largest listed company, the same relative position as Wal-Mart Stores in the US.The other group to look at is the companies on a p/e of 16 or lower that will meet or exceed current year profit forecasts and can repeat that performance in 2002.

Investors should never forget that, under normal circumstances, earnings drive the sharemarket. They are even more important in an economic downturn.

* bgaynor@xtra.co.nz