Vive la difference it's keeping our market stable

The message jumping out of this week's Statement on Monetary Policy from the Reserve Bank is clear: it's Wall Street, stupid!

But a second message is equally important: just because Wall Street's in trouble doesn't mean our sharemarket's in trouble too.

The Reserve left little doubt that it regards the uncertain prospects for sharemarkets as the greatest threat to our economy. But note how it gets from one to the other:

Our economy's going fine and looking fine, but the greatest risk to it comes from renewed weakness in the world economy. The greatest risk to the world economy comes from weakness in the US economy. And the greatest risk to the US economy comes from the reaction to any further declines on Wall Street.

There's nothing new, of course, about Wall Street or any other sharemarket going up and then coming down. So why make so much fuss about it this time?

Because this time is a much bigger deal. The Reserve notes three unusual things about the recent falls in US share prices.

First, this is the third year in a row that share price indices have fallen. Such long drawn-out falls are rare, having occurred only twice before over the past century.

Second, the cumulative falls are large. At one stage in mid-July, the Standard & Poor's 500 index was down by 48 per cent from its peak, the largest fall since the 1930s.

Third, the falls have continued despite the very substantial cuts in official interest rates by the US Federal Reserve (totalling 4.75 percentage points over the course of last year) and the signs of recovery in the US economy.

This episode of falling prices is so unusual mainly because the preceding rise in prices was so much bigger than before. In just five years, the S&P 500 tripled. Market capitalisation rose to a proportion of GDP that was unprecedented. And the ratio of share prices to share earnings (the P/E ratio) reached a peak of about 47 compared with peaks of about 27 at the top of previous booms, including 1929.

But get this: the fastest period of price increase, from 1997 to March 2000, occurred while corporate profits (as measured by the national accounts) were essentially flat. (Now you see why they call it a bubble.)

It's important to realise that, while Wall Street has been falling, so have other major sharemarkets around the world. From its peak in March 2000, the S&P 500 has fallen by about 41 per cent. Over the same period, the London market has fallen by 34 per cent, Canada's market by 31 per cent and Tokyo's by 45 per cent.

So there you have a demonstration of the conventional wisdom about the global equity market: when Wall Street falls, all the other sharemarkets around the world fall too, pretty much in lock step.

And if you follow what happens here, you could be forgiven for thinking that's our story, too. When you wake up on a weekday morning, the radio tells you whether Wall Street was up or down overnight, and our market usually proceeds to move in the same direction.

That's true but it turns out to be highly misleading. Cop this: over the same period that Wall Street has fallen by 41 per cent and all those other markets have fallen by roughly similar amounts, our market (measured by the new ASX 200 index rather than the old All Ords) has fallen by just ... 3 per cent.

(If you find that hard to believe, remember that though Wall Street and the others peaked in March 2000 just before the Tech Wreck our market didn't peak till March this year. So, though we've fallen by about 11 per cent since then, we've fallen by only 3 per cent since March 2000.)

How on earth has it been possible for us to defy the global trend to the extent we have? The standard explanation is: since we didn't go up us as far as Wall Street did, we haven't had as far to fall.

That's true enough, but in this week's SoMP (statement on monetary policy), the Reserve checked the story out more carefully. It took our ASX 200 index, Wall Street's S&P 500 and equivalent indices for Britain, Canada and Japan, then divided the stocks in each index into 10 industry sectors.

It turns out there's a reasonable correlation between the price movements of each industry sector in each of the five countries. For instance, each country's IT company shares have fallen by roughly the same extent.

This is what you'd expect in a more globalised world: not that all sharemarkets move together, but that the values of all the world's paper companies or car companies or whatever tended to move together (because those shares are reasonably close substitutes for each other).

(Even so, the Reserve's analysis revealed that our companies' share prices tended to fare better than the other countries' companies in five categories: finance, health care, general industrial, mining and telecoms.)

But the Reserve's most significant finding is just how different the composition of companies in our index is to the composition of companies in the S&P 500 and the other indices.

Taking the most extreme examples, our finance sector's capitalisation gives it a weight of as much as 44 per cent in our index, compared with less than half that for the finance sector companies in the US index. (That's mainly our Big Four banks, which between them account for a full quarter of our index.) As well, mining companies have a weight of 16 per cent in our index, compared with 3 per cent in the US index. On the other hand, IT companies account for 14 per cent of the US index (and 15 per cent of Japan's index), but less than 1 per cent of ours.

Now get your mind around this. The Reserve calculates that if the Australian market had had the same sector-by-sector weights as those for the US market in March 2000, our market would have fallen by 32 per cent, not the 3 per cent it actually did.

See the point? The main reason our market has held up so well compared with Wall Street is that the kinds of companies we have in our market are very different from those in the US.

This is encouraging news. It says there's a solid, sensible reason our sharemarket has been so little affected by Wall Street's long slide. And it suggests that, even if Wall Street has a lot further to go, it's not necessarily ``just a matter of time" before we collapse in a heap too.

But could our market be overvalued in its own right? Yes, but not by a lot, according to the Reserve's analysis. Surveys show our market is expecting earnings growth of 10 per cent this year and 13 per cent in 2003 which seems quite optimistic.

It's true that, since late last year, our P/E ratio has risen from about 20 to 27. But much of that rise is explained by the large losses incurred by News Corporation (which has a weight of 7 per cent in the ASX 200).

If you exclude News, the P/E drops to 18 which isn't a lot higher than the long-run average of about 16.

So, though there's obviously scope for Australian share prices to fall further, it's hard to see how it could turn into a bloodbath.