Cyclically-adjusted price/earnings multiples (CAPEs), as made famous by Yale’s Professor Robert Shiller, are growing inconvenient for the brokerage community.
Last week, BofA Merrill Lynch’s Savita Subramanian pointed out that of 15 popular measures of equity valuation, CAPE (which compares share prices to a 10-year moving average of real earnings) was the only one that made stocks look expensive. The list of valuations suggesting US stocks are either cheap or at fair value includes:
- trailing p/e
- forward consensus p/e
- trailing normalised p/e
- enterprise value/ebitda
- forward PEG (p/e ratio divided by growth)
- trailing PEG
- price/operating cash flow
- price/free cash flow
- enterprise value/sales
- market-based equity risk premium
- normalised equity risk premium
- S&P 500 in WTI oil terms
- and S&P 500 in gold terms
CAPE is thus beginning to stick out like a sore thumb. As it has been showing that stocks are expensive throughout most of the current rally, there is now a widening attempt to discredit or ignore it. Merrill’s own complaint is typical:
The Shiller P/E, which is based on inflation-adjusted earnings over the past 10 years, currently suggests that stocks are overvalued. However, this metric
assumes that the normalized (cyclically-adjusted) EPS for the S&P 500 is today less than $70—well below even our recessionary scenario for EPS. The
methodology assumes that the last 10 years is a representative sample, but the most recent profits recession was the worst we have seen and was exacerbated by a high leverage ratio which has since been dramatically reduced. Assuming that this scenario is going to repeat itself is, we think, overly pessimistic
But is it? Earnings volatility has certainly been extreme over the last decade, and arguably unprecedented. But if anything that suggests that the measure – which grew famous from efforts to predict the bursting of the dotcom bubble in 2000 and to show that the 2003-07 bull market was a “fools rally” – is more, not less, useful. That is the contention of Prof Shiller himself, and it is a reasonable one. More on this, with charts, and some comments from Prof Shiller, after the break. Read more
Let’s try to drill into the global picture for earnings, following on from Monday’s column. The picture is undeniably unexciting, but we need to take two divisions into account. First, financials have followed a different logic from the rest of the corporate sector over the last five years or so, for obvious reasons. Second, US companies have profited far more than companies elsewhere in the world, for reasons that are far less clear.
Let’s start by looking at the global picture, with and without the financials. Earnings per share for the MSCI indices (with thanks to Andrew Lapthorne of SocGen for providing this data) look like this: Read more
Ben Bernanke can move markets, and sometimes his words are too strong for his own good. That may have been true of his press conference last month, when he announced that he planned to start tapering off QE bond purchases later this year, and end them altogether by next summer. That drove a dramatic rise in Treasury yields, and in the dollar.
For a further classic example, look at the speed with which currency markets responded late on Wednesday and early on Thursday to a speech he made in Massachusetts, and to the minutes from last month’s meeting of the Federal Open Market Committee, published on Wednesday. The euro gained 4.5 cents against the dollar in a matter of minutes, while the pound gained almost 4 cents (or about 2.6 per cent). Read more
Value investors are getting excited about emerging markets again after their terrible performance over the past few months.
The problem, as Arjun Divecha, chairman of Boston’s GMO, says, is that mostly what’s cheap is commodity-related stocks set to suffer from the slowdown of demand in China. Domestically-oriented companies are down, but aren’t that cheap.
There are a couple of really cheap areas, though. He points to Russian oil shares, and Chinese banks.
Both have horrible fundamentals. Russia is stuck between recession-hit Europe and slowing China, and has some of the worst corporate governance in the world.
Chinese banks are directly exposed to the slowdown in the country’s economy, are being told to lend less (hurting profitability), face higher funding costs (hurting profitability) and risk the bursting of the credit bubble (which would expose the bad debts from their relaxed lending decisions of the past four years).
Given all that, shares would need to be very very cheap to consider buying them. And they are. Charts showing just how cheap Chinese stocks have become follow after the break. Read more
Americans have been wondering if the housing market is in a double bubble for a little while, since Professor Robert Shiller, co-creator of the Case-Shiller house price indices, raised the danger.
The real action has been in housebuilders, though. Their valuations, based on price to estimated book value, peaked in May above where they stood at the height of the property bubble in 2005/6. Prices look very much like the rebound bubble in the Nasdaq, in the Dow Jones Industrials in the late 1930s and in the Nikkei 225 (although it wasn’t quite so big). This chart shows the Nasdaq and Nikkei time-shifted so the peaks overlap with the 2005 peak in housebuilding shares:
I’ve circled the point where the rebound went wrong again: seven to eight years later for both Nasdaq and, less spectacularly, the Nikkei (the Dow’s second depression-era boom-bust came in 1937, also eight years after the original bubble).
More fab charts, including one must-see on why US housing isn’t as affordable as everyone thinks, after the break. Read more
The fun part of the eurozone crisis, if there is one, is that you never know where to look. After the Cyprus crisis three months ago, the hunt was on for the next small peripheral country that would create a headache. Slovenia was a popular bet. So, among some hedge fund managers, was the Netherlands, where house prices are dropping alarmingly. There was a frisson of concern about Croatia’s accession to the EU. But it turns out that the next country to administer a shock, two years on from its bail-out, is Portugal.
You do not need to be an expert in Portuguese politics to see that the country is in a crisis, or that local markets were shocked by developments. When the foreign minister hands in a resignation hours after the finance minister has done the same thing, over an issue of core economic policy, and the existence of a fragile coalition is called into question, then it is natural that prices will be revised. Read more
One of the biggest arguments for emerging markets during their bull market, which started in 2003, was about “decoupling”. The idea was that the emerging markets had now managed to decouple from the developed world, and would be impervious to a recession there. It never worked as it was supposed to, with the arguable exception of a few hectic months at the end of 2008 when China’s stimulus appeared to end. Now, I’d argue, the decoupling has ended, but not in a good way.
I discussed emerging markets with Barclays’ Larry Kantor in a Note video. That included the following chart, which shows that emerging markets have now underperformed the developed world over the last five years, a period that starts roughly with the crisis over Fannie Mae and Freddie Mac in the hot summer of 2008:
Significant EM underperformance when developed markets were performing well is a new experience for many currently operating in the markets. More detail (and charts) after the break. Read more
Shocking news from Bloomberg for goldbugs (as if they weren’t hurting enough):
Gold dropped 23 percent this quarter, heading for its biggest loss since at least 1920
Just a brief post to pass on a thing of beauty. Critics of market-capitalisation weighting for indices always complain that you are in effect always buying the companies that are most overvalued. There is a lot of truth in this.
In the chart, Ned Davis Research create an index with just one stock in it: the biggest by market value at the time. As soon as a company is overtaken it is replaced in the index of one by the new leader. Trivia devotees may like to know that there have only been nine such stocks in the last four decades: Apple; AT&T (though not in its present incarnation); Altria (once known as Philip Morris); Cisco Systems (beneficiary or victim of the most absurd episode of equity overvaluation in history); ExxonMobil; General Electric; IBM; Microsoft; and Wal-Mart. All are undeniably great companies that at some point since 1972 the market thought to be worth more than any other. Here is how these companies performed compared to the S&P 500, starting in 1972: Read more
Okay, if you have a spare second after liquidating your portfolio, here’s a quick dive into ancient history (pre-taper, or the week up to last Wednesday).
It turns out all that selling in the build-up to last week’s Federal Reserve meeting was flooding not just back into the US, but mostly back into US equities. Here’s a lovely chart of mutual fund flows courtesy of Orrin Sharp-Pierson at BNP Paribas: Read more
Amid the post-Bernanke rubble, there are probably a few people sparing time from hedging their interest rate risk to look for bargains.
Look no further: the gold miners are cheap! I mean, really cheap. Gold has tumbled a long way from its peak, but miners have fallen much further – and are now trading at an extraordinarily low multiple of the gold price. This chart shows the ratio of the Market Vectors Junior Gold Miners index of small miners, and of the Arca Gold Bugs index of larger miners, to the gold price.
Larger miners are now the cheapest relative to gold they’ve been since the aftermath of the dotcom bubble, when they proved a serious bargain. The index of junior miners only started in 2004, but their prices are testing the low relative to gold reached after Lehman Brothers collapsed – after which they offered some of the best returns of any stocks anywhere. Read more
Is there really any way that financial engineering could cure cancer? That was the argument that MIT’s great Andrew Lo made during a visit to London last week, and being an entrepreneurial finance professor he is now trying to bang the drum to get his idea off the ground. If he has his way, he will end up creating a $30bn cancer “super-fund” that will invest in 150 different anti-cancer projects.
It is if nothing else a fascinating idea. I wrote a Monday column on it, while the Economist’s Buttonwood (in real life a former Long View writer) blogged on it. Both of us came out broadly in favour. My video interview with Professor Lo appears here:
Andrew Lo on Cancer
Virtually all of us as humans would like it to work. Does it actually stand a chance? More on that after the break. Read more
Today’s Note video is with the MIT economist Bob Merton – famous both for winning a Nobel memorial prize for his part in drawing up the Black-Scholes options-pricing theory, and for his part at Long-Term Capital Management, the hedge fund that nearly brought down the world credit markets when it came to grief just a year later in 1998.
Prof Merton was talking about a profoundly important subject. We know that the world’s credit markets were dangerously interconnected entering the crisis. He and a team at MIT are now working out how to measure that interconnectedness, in the hopes that by understanding the phenomenon we might be able to get to grips with it better this time. The alarming finding is that credit is even more interconnected now than it was before the crisis. The video appears here:
As we tried to cover a lot of ground in under five minutes, some extra detail on how Merton produced his findings might be useful – see after the break. Read more
The US Federal Reserve’s support for the markets can be measured lots of ways, from the impact on bond yields through to comparisons of equity prices and the central bank’s balance sheet. Here’s one I rather like, with a hat tip over to BNP Paribas’s William De Vijlder.
The third round of the Fed’s quantitative easing, or QE∞, is now 41 weeks old, and during that time there hasn’t been a single really bad week, which I defined as a loss of 2.5 per cent or more. The last time there was such a long period without a big down week was during QE2. Before that it hadn’t happened since early 1997.
The total loss of all the down weeks since QE∞ began, including weeks with only a small loss (a somewhat odd measure, obviously offset by plenty of up weeks) has been just under 18 per cent, close to the lowest reached over rolling 41-week periods during the “great moderation” of 2003-2007, and to that reached under QE2. Read more
As the month draws to a close, the old “sell in May” strategy failed miserably for equity investors – except in Japan and emerging markets.
There are a couple of lessons from this May, but first here’s what the major assets did during May, first in local currency then in dollar terms:
Since the US is still open, both charts are up to the close of the 30th, for consistency, so not quite the full month; European markets today were down about 1 per cent, and Japan up just over 1 per cent, but the broad patterns remain the same. Read more
Here are the two Japan charts that matter after Japanese shares plunged more than 5 per cent today.
First, the Nikkei 225 Average is poised at the 50 day moving average, an important technical support level. If it recovers from here, this will be nothing more than a correction, if a big one, of the excessive optimism which had taken hold. From their peak last Thursday to today’s low Japanese shares were down almost 15 per cent – but are only back to where they stood a month ago. The rally can continue, as the futures market suggests, with futures prices and bond yields both rising sharply after the cash equities market closed. But once the current volatility settles down, a continued rally is likely to come at a far more moderate pace. Read more
Ooh la la! French consumer confidence figures just came in, and they aren’t pretty. The index just matched its lows from late 2008, itself the lowest ever.
So far, so eurozone. It isn’t exactly new news that the French economy is in terrible shape. But this chart shows how consumer confidence has broken away from share prices, something it usually tracks closely. Read more
While you consider the sell-off in Japan, here are a few charts, as of Thursday night prices:
Total returns (including dividends) on various asset classes for the year to date, in local currencies: Read more
The Nikkei 225 is down more than 7 per cent today, its 11th biggest daily fall since it was created in 1950. Explanations abound: the hawkish interpretation of Ben Bernanke’s testimony to Congress (although it can be read either way), the hawkish interpretation of the Fed minutes (ditto) and the surprisingly weak purchasing managers’ index from China, showing manufacturing shrinking slightly.
All these no doubt matter. But the real question is why markets chose to care today. China has been slowing for months, and while Fed-ology always moves prices, it was particularly hard to read anything much new into Wednesday’s comments. Read more
There’s been quite a bit of excitement about the Dax hitting a record high this week, with the Wall Street Journal even splashing its European edition on it. The chart looks impressive: