Funds flows are no measure of stability

It has become common for discussions on the factors influencing investment markets to refer to the ever-growing sums in superannuation. A significant proportion of this capital inevitably flows into the stock market and this, it is suggested, is a force that will keep stock markets strong.

This is called the ‘weight of money’ argument. Reduced to its most simplistic form, it suggests that this force is so strong that it will inevitably drive markets forward. We won’t have to worry about major downturns in the future.

And there really is a Santa Claus.

Regrettably this argument is false. It implies a suspension of the natural order which is cyclical in nature.

Basically the argument says there will be ever-increasing demand for stocks and this will increase their price. This is half of a logical position. If the supply of a product is fixed and the demand increases, so will the price.

The weight of money argument would be sound if there was an increasing demand for shares but the supply was fixed. However, the supply of shares available for investment has been increasing hugely in recent decades. To revert to economic jargon, the supply of shares is very elastic, ie as demand increases, it is easy to create more of the product to satisfy it.

This was demonstrated graphically in the technology boom where the demand for hi-tech stocks was huge, which led to the floating of an extraordinary number of new companies.

Existing companies can also issue new stock.

We have also seen the powerful global trend to privatisation, where governments sold off their assets via a stock market listing, such as the Commonwealth Bank, TAB and part of Telstra.

Another source of new share creation is the trend to reward senior executives with options, ie the right to buy new shares in their employer company.

The weight of money argument would only be sound if it could be demonstrated that, over time, the increase in demand for stock market investments would outstrip the increase in supply. I know of absolutely no research or argument in favour of this. In fact, there is a school of thought that the opposite has been the case in recent years and that the creation of new shares has been excessive.

Another fundamental flaw in the argument is that there are alternative products available to investors, ie shares are subject to competition. The impact of competitor products on the supply/demand economics is simple. If the price of soft drink rose it could encourage consumers to switch to mineral water, flavoured milk, fruit juices and so forth.

Exactly the same applies in investment markets. If the weight of money, or any other factor, forces the price of shares to too high a level, investors can choose to place their money in alternative investments, such as government bonds, cash and property.

Therefore, the weight of money argument could only be sound if there developed a world shortage of available investment opportunities which would drive up prices. It is impossible to hypothesise such a scenario.

For some strange reason the weight of money argument is only ever applied to the share market. Yet, if it were true that demand would inevitably drive prices higher, why would this not also apply to property and bonds? A portion of superannuation savings flows into these markets also.

This would suggest that nothing would ever decline from now on, everything being supported by the weight of money. Not only would there be a stock market Santa Claus but a bond Easter Bunny and a property Tooth Fairy.

It reveals much about the wishful thinking behind this argument that it is exclusively applied to shares — by people who wish to find some reason to satisfy themselves that they need not worry about stock market risk.

Economists tend to assume that consumers are entirely rational beings making logical decisions about allocation of resources. This suggests that economists must have never made the acquaintance of any actual consumers. It escapes me how anyone can develop a theory that the same consumers who, at various times, have had a craze for pet rocks, soap-on-a-rope or tongue studs, are making entirely rational economic decisions.

Markets are subject to whims or fashion, although some of these can be quite enduring. This includes investment markets.

At the end of the 1990s, tech stocks were the favoured brand of investment. In fact, research demonstrated that companies who changed their name to sound more technology oriented, but did not change their business activities in any way, generally saw their prices increase.

Tech stocks have recently suffered brand damage and have gone out of fashion.

However, the stock market itself is still the in fashion brand of investment. Of late, portfolios have had record levels of exposure to the stock market, ie a bigger proportion is going into that asset class than was the norm. Many commentators think it will ever be thus????????. It won’t.

There have been other periods of excessive inflow into the stock market and these have been followed by periods when it was out of fashion.

For example, Warren Buffet states that, in 1971, 91per cent of pension fund flows went into equities. By 1974 it was 13 per cent.

The aftermath from the crash of 1987 was another example. Shares suffered brand damage in the crash and went out of fashion. Property then became the hot item.

In fact, I first heard the weight of money argument prior to the crash of 1987 explaining why that boom could go on forever.

While I question the view that consumers are entirely rational, they are not entirely irrational either. Although fashion impacts demand and prices, in the long run, value for money always re-emerges as a force in the marketplace.

The reason that shares in a company have some value is that the company makes a profit. This raises the principle of price earnings (PE) multiples. To make a simple illustration, I will focus just on dividend yields.

On current prices, the average American share pays a dividend of less than two per cent. People are paying too much. You can get a better yield elsewhere, for example in US government bonds or Australian shares.

If the weight of money argument was sound however, it would mean that stock prices would not fall, merely because dividends were only two per cent. In fact, over time, they must rise, say to where dividends were one per cent. But the weight of money would still apply. Therefore stocks would have to rise until dividends were 0.1 per cent and so on.

Yet, at some time, markets will recognise a ludicrously small return and the flow of money reverses, ie out of the stocks and into alternatives, driven by value for money.

The fact that there is lots of money sloshing around in markets doesn’t make them stable.

I am prepared to make one firm prediction about the future — it will be like the past. It will continue to challenge us with phases of favourable and unfavourable conditions. You can legislate savings into superannuation, but you can’t legislate stability into investment markets.