When stock markets across the globe are sagging at 10-year lows or worse, it might seem a no-brainer just to buy the indices, if an investor has a long-term view. Index-buying is easy, no fuss and cheap. Another common strategy is to buy the “dogs” of the global stock community, on hopes they will bounce the most when the good times eventually get rolling again.
But actually, in down-times, “stock picking becomes even more crucial”, says Gavekal, the Hong Kong-based research and investment house. Indices – and therefore, index-buying – generally reflect the past more than the future, never a sound investment-strategy at a time of rising divergence:
“We note with some amusement that even Obama is now tipping the market, telling Gordon Brown that: “What you’re now seeing is profit and earning ratios are starting to get to the point where buying stocks is a potentially good deal, if you’ve got a long-term perspective on it”. We would add to this advice, that the “cheapest” are not always the best future performers. Banks are at their lowest price to book values ever – but perhaps for good reason with nationalization looming and many other threats to their future role (we saw an interesting article yesterday, where pension funds are doling out loans, since the banks cannot…). Our friends at ISI recently performed an interesting exercise, which showed that some of the worst-performing stocks since November failed to bounce during the brief-lived rally in January. This is yet another example of the need to stock pick carefully, even when engaging in bottom-fishing.”
On top of such admonitions, BreakingViews on Wednesday warns that what right now looks like a vastly under-valued Dow Jones Industrial Average could easily prove to have been a significantly over-valued one in a relatively short space of time.
Yes, the Dow is now firmly under 7,000, and the US stock market is now well below its early-1995 level, adjusting for changes in nominal GDP, says BreakingViews’ Martin Hutchinson. “That suggests it is cheap, assuming growth prospects are as good as they were back then. But there is a risk to such a an analysis: too much fiscal and budgetary stimulus could bring on growth-stultifying inflation.”
Fast back to December 5, 1996, he says, when the S&P 500 closed at 744.38 and Fed chairman Alan Greenspan subsequently warned of the market’s “irrational exuberance”.
With the S&P’s close of 700.82 on Monday, the market is clearly “exuberant no more”. But it is not exceptionally low, says Hutchinson, noting that, based on 1995 stock prices and long-term earnings considerations, the market is just below a middling valuation. That, however, assumes US growth and earnings prospects are “as good today as they were in 1995, or over the long-term average”:
That’s where doubts creep in. If the exceptional monetary stimulus since September produces inflation, which needs to be squeezed out, or the unprecedentedly large budget deficits in fiscal years 2009 and 2010 “crowd out” private investment, then growth and earnings prospects for the next few years would be below average. In that event, the market as it stands today would be overvalued. Bailouts and stimulus can thus produce long-term uncertainty as well as short-term uplift.
Meanwhile, on the subject of the direction of stock markets, the FT’s John Authers warns in his Short View column on Wednesday that “the bottom may soon be here”. This week’s brutal sales of stocks across the world brought indices to historic levels, he notes. But the harder questions are “how far stocks must fall to get there, and how long it will take to climb out”.
In the US, stocks have shown a strong trend for more than a century, growing by 6.75 per cent per year after inflation, with income reinvested. London’s Lombard Street Research points out there have been only 26 months in the past 140 years when the S&P 500 was further below this trend than it is now. All bar six, three each in 1932 and 1982, were caused by world wars.
Those two years marked the lows of the worst bear markets of the last century. So stocks look likely to stop getting cheaper quite soon.
Equity markets could, however, fall further before hitting bottom, Authers adds, noting that in 1932, stocks fell 25 per cent more after becoming this cheap compared with trend – but then doubled in a matter of weeks.
As for valuation:
It is almost impossible to say that stocks are expensive. Cyclical earnings multiples, a reliable long-term value indicator, are now much cheaper than their average for the last century, although they again imply that one further big fall is possible before reaching their lows of 1932 and 1982. The sell-off goes beyond financials, as earnings multiples on non-financial stocks are approaching their lows from the last bear market.
To take another measure, viewed in real terms, the S&P 500 was down 61.4 per cent at Monday’s close since its peak in 2000. Its decline in real terms from 1929 to 1932 (when there was deflation) was 79 per cent, while the fall from 1969 to 1982 was 62.6 per cent.
So any falls from here will be dictated by the economic data and it’s the strength of the economy that should dictate the speed of the recovery, concludes Authers.
After 1932, it took 26 years to regain the peak in real terms. After 1982, it took 10 years.
A happy thought….
Related links:
Dow Jones valuations are just getting tougher - BreakingViews
Short View: The bottom may soon be here – FT