The Hidden Logic of Bank Stock Prices

To the casual observer, the movement of bank stock prices seems unfathomable. For example:

* Bond and stock prices do better when the economy is in the doldrums than when it is very strong.

* The securities markets usually do very poorly in October and November and very well in January and February.

* Stocks of banks and industrial companies seem to follow different rules. The price-earnings multiple of an industrial can be closely tied to the company's return on equity, which is clearly not the case with bank stocks.

Despite these seeming anomalies, the markets for securities and for bank stocks follow a well-defined logic.

Managements that understand this logic can build in higher prices for their stocks.

In this article I will discuss some macroeconomic considerations. In a future Comment, I will address issues specifically relevant to the stock of banking companies.

A Natural Flow

The prices of financial assets are driven by expectations of relative real returns.

To command a higher price, an investment must offer a better payback than other financial assets of similar risk. Also, there must be an expectation that the relatively high real returns will continue for a sustained period.

At any given moment, it is very difficult for investors to assess these factors. That is why the securities markets are volatile and uncertain.

If a management can convince investors that its stock offers sustained, high, real returns, the stock price will soar.

Competition for Funds

Why is the stock market generally lackluster when the economy is strong and vice versa?

At any point in time, the amount of money in the system is limited. The financial sector and the rest of the economy compete for that money. In general, both cannot have it at the same time.

For example, in the 1970s the stock market rose by 2.5% a year as measured by the Standard & Poor's 500. (Indeed, by some measures there was zero growth in stock prices from 1967 to 1980.) Yet during the 1970s, corporate earnings as measured by S&P showed the fastest growth on record -- 10.5% annually.

Conversely, in the 1980s the S&P 500 soared by an unusual 11.4% per year, while earnings were growing only by an inflation-equivalent rate of 4.1% annually.

The explosion in stock prices occurred in the middle of the decade, when corporate earnings showed no growth. Upward movement in prices faltered only when corporate earnings started to grow once again.

Ebb and Flow

Basically, money was flowing from one to sector to the other according to which offered the highest return.

When the return on economic activity was good -- that is, when the economy was strong -- money flowed out of the financial sector into inventories, receivables, and capital expenditures, driving up interest rates and depressing securities prices.

When the economy was weak and the returns on inventories, receivables, and capital expenditures faltered, the flow was reversed (after working-capital shortfalls were paid for) and funds returned to the financial markets. Interest rates declined and security prices soared.

One might argue that the stock market led the economy up or down because the market felt the impact of excess or depleted financial flows first.

Full Circle

Consider what happens at General Motors Corp. through an economic cycle:

* When the demand for automobiles increases, the company's treasurer begins redeeming short-term investments to buy steel and build cars. As demand continues to grow, the company may actually borrow in the open market and expand manufacturing facilities. The company goes from being a net provider of funds to being a net user.

* As the economy begins to slow, perhaps because the cost of funds has now risen to so high that consumers have trouble financing the purchase of new automobiles, the GM treasurer reverses course. The returns on car production have turned negative, so funds are withheld from that activity and used to pay off debts and buy short-term securities. GM goes from being a net user of funds to a provider.

By making rational judgments concerning the expected rate of real return, the corporate treasurer moves funds into and out of the financial markets. Thus bond and stock prices do better when the economy is weak.

Christmas and the Markets

These cyclical determinants of stock and bond prices also have a seasonal flavor. Here are some startling statistics.

In the 64 years from 1926 to 1990 (when we did this study), the stock market rose 4.7% per year on average and yields averaged 4.4%. This means that the total return on stock investment averaged slightly over 9% for most of this century.

Incredibly, though stock prices have been in a long-term uptrend since 1900, the market has declined, on average, October and November.

In fact, 10 of the 15 worst declines recorded for stock prices in this century occurred in the September-November period, and seven of these were in October -- including, of course, the market crashes of 1929 and 1987.

In Januaries, though, the stock market does extremely well. In fact over the past 90 years, the first quarter and first half of the year have seen markets that consistently outperform those of the last half and last quarter. Established trends of this nature cannot be dismissed as flukes.

A Consumer Economy

If one considers the economy as a system in which money goes where real returns are highest, the market's seasonal activity becomes comprehensible.

The United States is predominantly -- about 70% -- a consumer economy.

And retail activity in the fourth quarter, stimulated by the holiday season, can almost equal expenditures in the first three quarters combined.

Holiday Ups and Downs

Consider what this means to the treasurer of Sears and its suppliers.

As the fall season approaches they must marshal all the cash they can, to put inventory into the stores for the Christmas selling season. At this time of year, the relative real returns for these companies are quite high for money invested in economic as opposed to financial activity.

In January, the Sears treasurer is viewing a totally different set of events. Ideally, the inventory has been sold, debts are paid down, and there is plentiful excess cash for investment in financial instruments. There is no need to reinvest in inventories, because the consumer needs time to recover financially from the Christmas buying orgy.

A Historical Parallel

One might also consider a well-established phenomenon that occurred in this country in the hundred years from 1850 to 1950.

In much of this period, the United States was largely an agrarian economy. Therefore, the major period of cash demand was in the planting season, and the major period of cash excess was at harvest time.

Fragmentary stock prices gathered for this era (mostly available for the 20th century) indicate that May was the worst month in the stock market, not October. This would be consistent with theory.

Furthermore, in the last half of the 19th century it was well understood that when the harvest failed, excess cash would fail to return to New York and there would be a crash and a recession. The depressions of 1873, 1883, and 1893 reflected such money panics.

The cyclical and seasonal money factors can be particularly devastating if both cause a drainage of funds from the financial sector at the same time.

This occurred in the fall of 1989, when the economy was steaming ahead, the holiday inventory buildup began, and the Federal Reserve slowed money-supply growth.

The problem was exacerbated when the regulators began their witch hunt through the banks, further restraining credit growth. The ultimate result was a weak financial sector -- and by mid-1990, a recession.

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