Companies react as stock options expensing takes effect

In the aftermath of accounting scandals in the United States involving companies like Enron and WorldCom several years ago, regulators and financial industry experts initiated a thorough review of regulations that affected corporate transparency and governance. The impact of the scandals were so far-reaching that many other countries and accounting bodies other than those in the US carried out their own reviews.

One of the widely-discussed recommendations was that regarding the change to the accounting rule on the treatment of stock options. It was felt that the issuance of stock options by a company to its management encouraged the latter to hoard cash and, in the absence of proper accounting of its dilutive effect on the holdings of the other shareholders, masks the costs incurred by the latter.

On 16 December 2004, the Financial Accounting Standards Board in the US published a rule that states that, starting June 15, US companies will be required to expense stock options. Some US companies, especially in the technology sector, are reported to be unhappy about this ruling, which they claim hampers their ability to issue stock options to attract talent.

However, opponents of the rule still have time to lobby Congress and the Securities and Exchange Commission, both of which could override it. The Republican victory at the November election last year in particular opens up the possibility that Congress will overturn the rule, as some of the newly-elected Republicans are said to support diluting the expensing rule.

In contrast, a similar ruling is already in effect in Singapore. Not surprisingly, it is creating similar unhappiness in Singapore.

In a report in The Business Times entitled "Options expensing forces rethink on staff rewards" on 12 January, Michelle Quah wrote that "corporate compensation in Singapore is changing with the new year, as a new accounting rule compels companies to expense their stock options".

The new rule that she refers to is called FRS 102, which stipulates that from 1 January this year, listed companies must expense their stock options, measured at fair value.

According to Quah, this new rule "has changed the way the compensation game is played". Some companies are moving away from stock options towards performance-based share plans, she said, "because they realise they will have to account for these options as an expense from this year".

Stock option expensing is, of course, just an accounting change. It does not change the fundamentals of the company. The question is: Why should a mere accounting change affect the way a company compensates employees?

One possible answer is that accounting for stock option expenses is difficult -- there is no standard way of accurately assigning the cost of a stock option. Then again, there are plenty of accounting rules for which there is no standard and accurate way of complying. Companies have always found a way to live with them.

The more sinister interpretation is that the rule is having its intended effect. Managements who had been using stock options to pad profits and present a pretty face to investors can no longer do so. Thus, there is no longer any point in using them.

Determined managements, of course, can still find other creative ways to hide compensation expenses -- or any expenses for that matter. Those who have nothing to hide, though, will see less need to change compensation practices. For examples, according to Quah, Keppel Corp and CapitaLand have both decided to continue with the use of share options.

Ultimately, stock option expensing is just another part of the moves to improve the transparency of management action. A management that acts in the true interests of the company and its investors should have nothing to hide and therefore should have no fear of stock option expensing.

Poor start to 2005 for US equities

US equities ended the first week of January 2005 in the red. The Standard & Poor's 500 was down 2.1 percent, the Dow Jones Industrial Average was down 1.7 percent and Nasdaq was down 4 percent. However, if there is any reason to worry about US equities for this year, this is not it.

In a commentary for CBS MarketWatch on 4 January titled "What's so special?", Mark Hulbert questioned the significance of the performance of stocks in the first week of January.

He pointed out that over the past 108 years -- since 1896, when the Dow Jones Industrial Average was created -- there have been 72 years in which this market benchmark rose over the first five trading sessions of the year. On average during these years, the Dow rose 6.88 percent from the end of that fifth trading day through Dec. 31.

For the 36 years since 1896 in which the market declined over the first five trading days of the year, the Dow on average rose 6.98 percent thereafter through the end of the year.

Hulbert gave more compelling reasons to be concerned in a commentary titled "Stocks are not cheap" on the following day.

Citing research by Clifford Asness of AQR Capital Management and Anne Casscells, formerly the chief investment officer for Stanford University's endowment and now chief investment officer of Aetos Capital's absolute return business, he points out that the P/E ratio of 16.1 for the S&P 500 based on projected earnings was 46 percent higher than the long-term average. Using trailing earnings, Hulbert said that the S&P 500's P/E ratio of 20.6 was 50 percent higher than what the two money managers reported the median P/E to have been between 1871 and 2003.

As Hulbert puts it: "The S&P 500's current P/E ratio is either 46 percent above historical norms or 50 percent above. Your conclusion in either case should be the same: Stocks aren't cheap."

That does not stop others from issuing bullish forecasts.

A BusinessWeek survey of analysts near the end of last year found that the majority of them see a rise of between zero to 15 percent for stocks. A more limited survey by SmartMoney revealed six bulls and three bears.

In his latest commentary for SmartMoney, Donald Luskin of Trend Macrolytics sees "good things" ahead. He says that "we are in a strong economic expansion that has no reason at this point to lose steam. Orderly rate hikes through the rest of the year will help, not hurt".

Luskin was optimistic for 2004, and rightly so as it turned out. Whether his optimism for 2005 is correct obviously remains to be seen.

The rate hikes that Luskin sees coming is usually bad for stocks. It is possible that "orderly" rate hikes may mean something different, although Luskin does not explain how such hikes differ from normal ones.

Luskin also points out that while "S&P 500 earnings were up 23.6 percent in 2004, stock prices themselves advanced by only 8.9 percent. That means there's a lot of upside still to be captured".

My take on this is different. Stocks anticipate the future. If stock prices did not advance as much as stock earnings in 2004, that is probably because at the beginning of the year, prices had already discounted much of the year-ahead rise in earnings. There may not be much upside -- if any -- to be captured.

In my opinion, we are already advanced in the current economic expansion. While the economy is likely to continue to expand in 2005 and earnings are likely to continue to rise at a healthy pace, the risk of a weaker-than-expected economy while the Federal Reserve is on a tightening bias is real, especially as we approach 2006.

While some may argue that 2006 is still a year away, remember that stocks anticipate the economy by between six to nine months. And if Mark Hulbert is correct in saying that S&P 500 stocks are between 46 to 50 percent overvalued, the ensuing fall in stock prices may be large.

The time to turn defensive -- if not outright bearish -- may be closer than many people think.

Stormy 2004 makes way for challenging 2005

2004 has ended and, while some forecasts made at the beginning of the year went according to script, as usual, the year had its fair share of surprises for markets. Pundits will, no doubt, be looking forward to the new year with new forecasts in a very challenging environment for market predictions.

Arguably, the most unexpected event of the year came on 26 December, when an earthquake registering 9.0 on the Richter scale hit the Indian Ocean floor off the west coast of the Indonesian island of Sumatra. The earthquake triggered a tsunami that has taken -- as far as is known at the time of writing -- over 140,000 lives. As some commentators have described, it is a disaster of truly biblical proportions.

Those countries directly hit by the earthquake and tsunami -- Indonesia, Sri Lanka, India and Thailand -- will have to bear the cost of reconstruction, which is likely to stretch beyond 2005. Their travel-related industries -- the airlines and tourism -- is also likely to be affected. Insurance companies will also be hit, but for insurers, the hurricanes and typhoons that hit the United States and other parts of the world earlier in the year probably had greater impact.

Compared to this cataclysm, everything else that happened in 2004 seems relatively mild.

There were plenty of elections in 2004. President George Bush was re-elected to the US presidency. A few countries saw changes in leadership, including India and Indonesia.

Stock markets around the world did well, with most major markets ending well into positive territory. In this regard, there was little surprise: stock markets generally do well in the year of a US presidential election.

	Start of 2004	End of 2004	Percent change
S&P 500	1,111.92	1,211.92	9.0
Nikkei 225	10,676.64	11,488.76	7.6
Hang Seng	12,575.94	14,230.14	13.2
Straits Times	1,764.52	2,066.14	17.1
FTSE 100	4,476.9	4,814.3	7.5
DAX	3,965.16	4,256.08	7.3
CAC 40	3,557.9	3,821.16	7.4

Bonds, however, behaved contrary to expectations. At the beginning of the year, most analysts had expected interest rates to rise. The US Federal Reserve obliged by raising the target federal funds rate, but the yield on 10-year Treasuries finished the year at 4.22 percent, down from 4.25 percent at the end of 2003. The difference in yield between the 10-year and two-year Treasuries is 115 basis points, compared with 242 basis points at the start of the year.

One of the reasons for the stubbornly low long-term bond yields was Asian central bank buying. Determined to maintain the competitiveness of their economies through weak currencies, many Asian central banks, notably Japan and China, have been buying US dollars, which are then recycled into US bonds. This persistent buying has helped keep long-term bond yields low.

Despite Asian central bank buying, however, the US dollar fell against the yen and the euro for the third year in a row in 2004. The US currency fell 7.1 percent versus the euro and 4.3 percent against the yen as the US current account deficit ballooned to new records, hitting US$164.7 billion in the third quarter of 2004, 5.6 percent of US gross domestic product.

Commodities rose in 2004, fueled by surging demand from China. Gold rose in tandem with the fall in the US dollar. However, it was oil that stole the show. Crude oil prices rose 34 percent through the year, with Brent crude for February settlement closing at US$40.46 a barrel and NYMEX light sweet crude closing at US$43.45 a barrel after hitting a record US$55.67 in October.

So what will 2005 bring?

Analysts are generally sanguine about equities in 2005. The US stock market is expected to show a small gain. Europe and, especially, Asia are expected to perform better on better valuations. But how equities perform will depend on how the economy and other markets perform.

Interest rates are generally expected to rise in 2005. Of course, that was also what analysts expected in 2004. Nothing can be guaranteed. Indeed, inflation, one of the key drivers for interest rates, was generally below expectations in 2004, despite the surge in oil prices. Some analysts are expecting another surprise on the downside for inflation and long-term bond yields in 2005. A flattening of the yield curve -- a reduction in the difference between long-term and short-term yields -- may be a bad sign for equities.

Interest rates in Europe and Asia especially may be capped if anticipation of further weakness in the US dollar drives capital into these markets. Most economists acknowledge that to reduce the current account deficit, the US dollar needs to fall further, especially if the Bush administration fails to curb the other US deficit, its budget deficit.

Oil is expected to fall in 2005, with both Brent and NYMEX crude oil expected to average below US$40 a barrel. Much will depend, though, on whether China's demand for oil moderates and by how much. 2004 saw the Chinese economy moderate, albeit slightly. If it continues to moderate, or worse, suffer a hard landing, oil prices -- indeed prices for many commodities -- may see significant falls.

Finally, the performance of all of these markets will depend on the performance of the world economy. Most economists see a moderation in economic growth in 2005, but no recession. An increasingly indebted US consumer -- the engine of global growth for the past few years -- will have to curb his spending and rebuild his savings, but an outright collapse in US consumer spending is not expected.

A slowdown in spending by US consumers will have to be made up with spending from other sources. US corporations are relatively cash-rich and many analysts expect to see this cash make its way into the economy, either through corporate investment or by having it returned to investors. Other potential sources of increased demand include Europe and Asia, especially if rising currencies boost consumer spending.

However, it is far from certain that these sources of demand will manifest themselves in 2005. Should the highly-indebted US consumer start cutting back on spending but these alternative sources of demand growth fail to materialise as hoped, the expected moderation in economic growth may yet be turned into an outright recession.

Yes, I think forecasting for 2005 will be very challenging indeed.