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Secret behind US markets' rise
Vinod K Sharma | May 05, 2007
The recovery in our markets has been aided by a resurgent Dow that has gone on to record yet another all-time high this week.
For the record, the Dow Jones Industrial Average closed at a high of 13,241 on Thursday. The benchmark has been a firm feature, rising in 22 out of the past 25 sessions, its longest winning streak since 1929. The S&P 500, too, has reclaimed the 1,500-mark after seven eventful years.
The rally in the US markets has helped extend our gains, which were on the verge of being frittered away after the April derivatives expired last week.
The US markets are an enigma to the lay investor. How on earth could the Dow rise to a new high if the US economy grew at its lowest rate (1.3 per cent) in four years in the January-March quarter?
The answer lies in the all-time high profits posted by US companies for the quarter gone by. But how could the corporates do so well if the economy's growth rate was slowing?
The weak dollar does all the explaining. For the S&P 500 companies, around 50-odd per cent of the revenues come from exports. So as long as India, China and others are doing well, the US companies can afford to do a jig.
But there's more to the US markets than a mere weak-dollar story.
Contrary to the Indian and the Chinese markets, where the supply of paper is exploding with newer issues and follow-up offers, the US markets have seen a reduction in the listed companies and also in the outstanding equity.
The S&P 500 stocks have seen a buy-back of around $450 billion worth of company shares last year, more than the $349 billion repurchased in 2005 and nearly triple the $131 billion in 2003.
No wonder that the PE for the S&P 500 and the Dow is undergoing contraction for the third year in a row.
Buy-backs prop up stock prices and pad EPS by reducing the number of shares outstanding.
Buy-backs are partly in vogue also because of the management practice of using EPS as a measure of performance, where the objective is clearly to give more bonus pay-outs to senior executives.
But yet another reason for the US markets to do well is the lapping up of listed companies by private equity players. This helps the markets to remain buoyant in three ways.
First and foremost, the delisting comes at a premium to the prevailing market price, usually in a 15-35 per cent band, which raises the valuations of the entire sector temporarily.
Secondly, the number of tradeable stocks goes down in the markets, helping to reduce the supply.
Thirdly, the investors who sell their shares in such open offers redeploy their money to buy other stocks, which acts as a fuel for stock prices.
Then you have the takeover tycoons, who are continuously on the prowl. Recently, News Corp's unsolicited bid for Dow Jones & Co stunned the market with a 65 per cent premium on the last market price. Offers like these raise the valuation of the sector.
How are the PE investors able to give fantastic returns to their investors, despite buying stocks at a premium from the market? The answer lies in gearing. If a company with a debt equity of 2:3 increases its debt to 4:1, the 10 per cent returns automatically results in 30 per cent.
The listed companies themselves are beginning to learn the use of debt all over again. IBM, for instance, which has announced a $15 billion programme to buy back its 10 per cent equity, will borrow a considerable part of the outflow.
In the current year, it is expected that companies will buy back stocks worth $400 billion and another $650 billion worth of stock will do a disappearing act under the coat of the private equity evangelicals. And this time, the catches could be bigger.With the private equity players themselves going public, the PE story has come full circle. But this will further buttress their financial strength and more listed companies could be bought off the exchanges.