The bad news for North American stock markets began last week when U.S. computer giant International Business Machines Corp. reported its financial results for the first half of 1995. IBM’s revenue was up a healthy 16 per cent compared with the same period a year earlier, and its profit soared 200 per cent to $4.1 billion, exceeding analysts’ expectations. But company chairman Lou Gerstner mildly cautioned that the rest of the year might be a little slower. And the stock market, which, for most of July, had been charging ahead, reacted sharply to IBM’s announcement. It immediately chipped 25 cents off its share price, which fell to $145.87. The market then proceeded to punish other technology stocks, including Canadian issues such as Corel Corp., which fell 75 cents to $24.75, and Delrina Corp. shares, which were off 50 cents to $19.75. A day later, optimistic comments by Federal Reserve Board chairman Alan Greenspan about the state of the U.S. economy and the resulting prospect of higher interest rates, knocked stock markets into a full-blown sell-off. Technology companies, which had been the largest gainers in recent months, were the biggest losers. The declines hit individual stocks differently: IBM dropped more than $8 to $138, Corel fell $1.25 to $23.50, and Delrina tumbled by $1.37 to $18.37. Although the technology sector suffered the worst declines, virtually all the sectors were hurt. “When they pull the plug out of a bathtub,” said John Ing, president of the Toronto investment house Maison Placements Inc., “all the ducks go down.”
Following the often-convoluted logic of financial markets, last
week’s good news for the economy translated into bad news for stocks. Evidence of economic strength usually implies that interest rates, one of the most important influences on share prices, are more likely to rise than fall, as central bankers attempt to avoid the inflation that often accompanies prolonged growth spurts. Higher interest rates make the returns on equity investments relatively less attractive, and this time around, that meant that share prices might not get the boost that many investors had been anticipating from lower rates. And when they grasped that shift in sentiment last week, some stockholders abruptly sold their holdings to lock in their profits. “In the high-fly• ing technology stocks, some people have doubled their money this year,” said Jean Hough, a retail stockbroker at ScotiaMcLeod Inc. in Toronto. “They’re just taking some profits.” Hough adds that she considers the sell-off to be nothing more serious than a correction. Hough, like the general consensus that has emerged since the plunge, expects that stocks will resume their climb soon. But she also says that she—and many of her clients, as well as other market watchers— have begun to wonder when the bull market will end. “Speculation is rampant,” she said, noting that reckless speculation is often one of the warning signs that the market is on the verge of a crash.
Many economists were also jolted by the slight decline in interest rates that triggered the market collapse. They blamed the sequence of events on a sudden swing in mood about the strength of the U.S. economy. In the past two weeks, almost every reported economic statistic has shown that the North American economy is reviving from the
The Toronto Stock Exchange composite 300 index
weaknesses that, earlier in the year, threatened to bring on a recession. Lower interest rates caused housing and auto sales in Canada and the United States to edge back up a little in June.
In addition, inflation in the United States, where economic growth had surged in 1994, seems to be contained: it edged up only slightly in June when it hit a moderate annual rate of 2.9 per cent for the first half of the year. In Canada, where the economy is weaker, inflation, as measured by the consumer price index, was running at an annual rate of 2.7 per cent in June. “Some of the numbers are coming out better than expected,” said Aron Gampel, deputy chief economist with the Bank of Nova Scotia. “And that doesn’t translate into good news for interest rates.” Gampel said that the stronger economic showing does not mean that interest rates will start rising again soon, but there is less chance that they will fall more.
That change had an immediate effect on the market’s psychology. “The stock market has been on wheels lately because of expectations that interest rates would come down more,” said Sherry Cooper, chief economist with Nesbitt Burns Corp. Ltd. in Toronto. “It’s not surprising that the market would correct now that that seems less likely.”
Last week, Greenspan dashed the expectation of lower rates when he appeared before a committee of Congress and gave an unexpectedly optimistic assessment of the U.S. economy. “We may have passed the point of maximum risk,” he said, referring to the possibility of a recession.
But he said, “the most probable [outlook] is for an upturn in the growth rate over the rest of this year and a moderate pace of expansion next year.” The financial markets took that to mean that Greenspan believes the economy is healthy and will probably not need more rate cuts. That caused stock and bond prices to tumble.
Clearly, Greenspan’s comments on July 19 caught the markets by surprise. Less than two weeks earlier, the Federal Reserve had cut the federal funds rate for the first time since 1992, apparently because the Fed feared that the economy was about to stall. After hiking the rate from three per cent in early 1994 to six per cent, by early 1995, in a bid to slow feverish U.S. economic growth, the board cut it by one-quarter of a per cent to 5.75 per cent on July 6. The Bank of Canada immediately
A healthy report rocks the stock market
followed with its own one-quarter-point cut in the cost of the overnight money it lends to financial institutions, and the chartered banks, in turn, cut their prime rates by a quarter of a percentage point to 8.5 per cent. The U.S. rate reduction followed on the heels of remarks made by Greenspan a month earlier, when he conceded that a rash of weak economic statistics indicated “that the probabilities of a recession have edged up.”
Although the abrupt change from that comment to last week’s optimism was unusual for the head of the Federal Reserve, Greenspan has been breaking new ground with his monetary policy since February, 1994. At that time, the Fed began raising interest rates well before any signs of serious inflation had appeared. As to what the Fed’s next move will be, Cooper noted that when it starts lowering interest rates, it usually cuts them several times in a row, and the total amount of the cuts usually amount to much more than one-quarter of a percentage point before it finishes easing.
But in the past 18 months, the Fed has experimented with a new approach in its interest rate policy that is aimed at heading off inflation before it starts. As a result, historical patterns are less useful indicators of the future. However, Cooper says that she sees some similarities between the current period and 1986. At the time, the economy slowed down dramatically after three years of growth and then surged ahead in 1987, leading the stock market first to big gains and then, in October, to a major crash.
Already by mid-1995, the economy has been expanding for four years and stock markets have climbed to record-breaking heights. Since the beginning of the year, the Toronto Stock Exchange composite index of 300 companies gained 500 points to a high of 4,718, before last week’s rout knocked the market down 88 points to close at 4600. And the New York Stock Exchange and the NASDAQ market, which specializes in smaller, technology-related stocks than the NYSE, had soared even more as investors bet that interest rates would be forced to fall. Even after the sell-off last week, Toronto was still ahead 13 per cent since the beginning of the year, New York was up 23 per cent and NASDAQ has gained 32 per cent. Technical analyst Leon Tuey of Leon Tuey Inc. in Vancouver, believes the market still has another sustained rally to make before it turns bearish. “Not only is there no recession,” said Tuey last week before the sell-off, “the market is telling us that sometime late this year onward we’ll see stronger growth in the United States. When that happens and interest rates start to rise, there will be one hell of a shock.”
And a shock, albeit shortlived, is just what happened last week. “I don’t think the correction will last long,” Tuey said. “It will be a good buying opportunity.” But he also suggested that the bull market could be approaching its third and final stage before a major setback arrives. “The final leg is usually short, sharp and driven by speculation,” he said. “It’s when fools rush in after many years of sitting on the sidelines. I think next year we could witness a sizable blow-off. It’s going to depend on how long the economy keeps going up.”
Already, there are clear signs of overheating in the Canadian market. Retail investors recently began a significant move back into mutual funds. Since less sophisticated retail investors tend to return to the market when it gets near the top, a booming mutual fund industry is often seen as a sign that the market is near a peak. Net mutual fund sales hit $1.5 billion in June, compared with a drop in sales of $900 million in the same month a year ago. Sales are up from $680 million in May.
Still, other indicators suggest that the stock market has significant room to rise before it hits the ceiling. The key ratio of stock prices to earnings remains at a historically reasonable level of about 14 :1 on the Toronto exchange. That means that even though stock prices have climbed this year, soaring corporate earnings have kept pace. Individual sectors, in particular the technology stocks, have become more overvalued. Price-to-earnings ratios, a key measure of the cost of a share for each dollar of profits that it earns, have been soaring in the technology
sector. While an affordable price-to-earnings ratio is usually considered in the range of 12 to 15 for each $1 of earnings, some technology stocks have ratios three and even four times that level. Before the market collapse last week, Corel’s price-to-earnings ratio was about 30 and Delrina’s was almost 20. But stock prices in other sectors, such as the cyclical resource industries, have remained relatively low because the buying frenzy has not struck them yet With earnings continuing to climb in most industries, that suggests that many stock prices still have room to rise, and therefore the stock market can still climb.
In addition, the small-capitalization stock segment of the market is still trading at low price-to-earnings ratios. Small-cap stocks usually boom in the later stages of a bull market. Sue Coleman, a mutual fund manager who specializes in the stocks of small companies for Altamira Management Ltd. of Toronto says that most of the so-called small-capital stocks are still undervalued—even though their fundamental financial performance is improving. “In the U.S. market, the high-tech sector has really taken off: there are companies with prices 40 or 50
times earnings,” said Coleman. “Maybe that’s expensive, maybe not. But the Canadian market still looks like it has stocks with lots of value.” Coleman says the price-to-earnings ratio of one index of smalland medium-cap stocks is just $11 for each $1 of profits, a level that suggests bargain stocks can be found.
For his part, money manager Ira Gluskin, of Gluskin Sheff and Associates Inc. in Toronto, is also optimistic about the potential of the stock market. He says that he is con-
vinced that the economy is heading for a long period of slow but steady growth. “This is nothing like 1987,” he stated. “In 1987, the economy was booming, not crawling along like this.” Gluskin insists that the economy is positioned to experience a prolonged period of low-inflation growth. And he says that he is even warming to the technology sector, despite arguments that it is overvalued now—and the fact that he owns almost no technology stocks at the moment. He cites IBM as an example of a technology company whose shares are still trading at a reasonable price. “It’s a leading company in a leading industry,” he said, “and the shares are trading for not that much more than 10 times earnings. What’s not to like?”
But Gluskin’s most convincing argument for buying into the stock market now is his view of the market’s state of mind. “In a socalled bull market, everybody’s euphoric,” Gluskin said, “and the market just ignores bad news.” Last week, the stock market certainly reacted to the bad news, even when it was good.
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