Are We Headed for a Second Great Reversal?

Global Financial Data has added Share Value Indices for over 90 global markets with over a century of data for major countries.  Share value indices allow analysts to determine how the number of shares outstanding has changed over time in order that they can differentiate between changes in price as a source of changes in market capitalization and changes in the number of shares outstanding in market capitalization.

Market capitalization is calculated by multiplying the price of shares by the number of shares outstanding.  The number of shares outstanding can increase as a result of a company raising capital by issuing new shares to the public, or by issuing new shares in order to take over a company that was previously private.  Companies that do an initial public offering and sell these shares to the public also increase the number of shares outstanding.

The share value index would NOT change if there were a stock split or stock dividend since this would have no impact on the market capitalization of the company.  If one publicly traded company bought out another publicly traded company, no change in the share value index would occur since the shares would simply be transferred from one company to  the other.

The share value index would decrease in value if a company went private, removing their shares from the public’s hands, if a company were nationalized by the government, or if the company purchased its outstanding shares, reducing the number of shares in the hand of the public.

The share value index is calculated by taking the value of shares outstanding and dividing this by the value of that index.  If the stock market index and the market capitalization double in price, there would be no change in the Share Value Index. 

Share Value Index and Stock Market Index Changes in the 1980s and 1990s

A good example of how the Share Value Index can explain changes in the stock market is illustrated by the dramatic change in the global stock market in the 1980s.  The graph below measures global stock market capitalization as a share of GDP from 1900 to 2018.

As Figure 1 illustrates, there was very little change in the ratio of global stock market capitalization to GDP between 1900 and 1980.  From 1980 to 2000, there was dramatic growth in the ratio, peaking in 1999. This was literally a once-in-a-century change in the stock market.  What caused it?  Was it because companies issued more shares to the public, or was it because of a dramatic increase in the price of stocks?

Shares Outstanding or Price Changes?

The Share Value Index for global stocks is provided below. As can be seen in Figure 2, the number of shares outstanding has steadily increased over the course of the past 100 years with most of the increase coming after 1990 as hundreds of new companies issued shares to the public.  However, the growth in market capitalization slowed in the 2010s, leaving overall market cap lower in 2018 than it had been in 2010.

If you look at GFD’s World Index adjusted for inflation provided in Figure 3, you can see several distinct trends.  There was little change in the index, after adjusting for inflation, from 1920 until 1980.  There were bottoms in 1921, 1932 and 1948 and peaks in 1929 and 1937.  There was a steady increase in the value of the index between 1948 and 1960 as the world recovered from World War II, followed by a plateau until 1973 when stagflation drove markets down for the rest of the decade.  However, the greatest change in the World Price Index occurred between 1982 and 1999 when the index increased five-fold from around 150 to almost 750.  It then lost half of its value in 2000-2001, regained its 1999 high in 2007, fell back in 2008 and now has reached new highs.  Although there was a large increase in the Share Value Index between 2000 and 2010, it appears that most of the increase in the market capitalization/GDP ratio came from an increase in the price investors were willing to pay for stocks, not in the number of shares outstanding.

This leaves the question, why did this once-in-a-century adjustment in the price of shares occur between 1982 and 1999? It should be remembered that long-term government bond yields decreased dramatically after 1981.  The yield on the 10-year government bond fell from 16% in 1981 to 5% by 1999.  This lowered the discount rate on future cash flows to corporations and contributed to the increased value of stocks and other financial assets.  

Investors wanted to pay more for stocks in the 1980s and were willing to receive a higher proportion of their return in capital gains than in dividends.  The dramatic decrease in personal tax rates under the Reagan administration encouraged the shift from dividends to capital gains.  Figure 4 shows the world dividend yield between 1925 and 2018. The yield had averaged between 3% and 6% between 1925 and 1982 with 4.5% the average yield.  Between 1980 and 2000, the dividend yield moved down steadily and today it averages around 2%, about half of the level between 1925 and 1980.  

It should be remembered that since 1981, yields on government bonds have dropped throughout the world.  During the past few months, markets have edged into a bear market as interest rates on U.S. Government bonds pushed above 3%, levels that would have led to a bull market 20 years ago.

So what changed investors’ perceptions of risk and their valuation models of the market? The 1980s and 1990s saw the world move from the closed financial markets that had prevailed in the world between the Great Reversal of 1914 and the 1970s and into a Globalized world that had prevailed before World War I undid the globalization of the 1800s.  If you combine this with lower yields on government bonds, the privatization of nationalized corporations, the growth in stock markets in former Communist countries, lower interest rates and lower tax rates, you have a once-in-a-lifetime shift in global financial markets.

It may be fears of a second Great Reversal, in which governments reject globalization in favor of global competition through political intervention that has driven markets down during the past few months.  Unfortunately, if this is the case, a drop back to the levels of 2000 and 2008 remains a possibility. Let us hope that global leaders can see the folly of their actions and reverse course before it is too late.