Stockmarket bounce is insignificant
Posted on April 9, 2009 by Richard Beddard
Filed Under Investing, Markets |
In practice:
The market is cheap I tell you
Despite the recent bounce in the UK stock market, it’s still cheap.
The 200-point rise in the FTSE All-Share from 1,800 in early March to over 2,000 is trivial relative to its descent from 3,400 since 2006, so investors are still unenthusiastic about shares.
By comparing the price of shares to the reward, in terms of profit, investors can expect, we can see how little perceptions have changed.
Since we don’t know how much profit companies will make in future, we estimate or use historical earnings as a guide.
Estimates are notoriously inaccurate and tend to use the recent past as a guide anyway. Analysts assume recent profit trends will continue, and extend them into the future.
Using the most recent year of earnings doesn’t tell us much either, as it might be a year of freakishly high profits, or freakishly low profits. 2007, 2008 and 2009 are certainly looking freakish.
Taking the average of five or preferably ten years of profits, including good and bad years, is a more realistic guide. Arguably it’s conservative, not a bad thing, because in the long-term companies grow. On the other hand, the last ten years may have been freakishly profitable since we haven’t suffered a full-blown recession since 1991, outside of the range of the long-term PE.
It’s not a perfect measure, but I think it’s a good one, and since December 2007 I’ve computed the long-term PE of companies listed on the London Stock Exchange (main market and AIM) with a profit history of five or more years and averaged it to produce a market PE:
Here’s the chart. It tells a sorry story:
In 2007, expectations were high. The long-term PE ratio was 20; meaning investors paid twenty times average earnings to invest in the stockmarket. Investors were happy to pay so much because they expected company profits to grow, giving them a higher return than the 5% average annual return implied by the long-term PE.
In early March, the market’s PE fell to just eight and the recent recovery has bounced it back up to nine, where it’s been since October 2009. Different people compile long-term PEs in different ways but normally a single-digit PE is very cheap. Long-term investors paying nine times earnings can expect an 11% return in an average year ahead (although it’s most unlikely to return 11% in any particular year) assuming companies remain as profitable in the future as they have been on average this decade (including the nearly-recession of 2003).
Maybe you find that reassuring, maybe you don’t, but one thing’s for sure: the rise in the stockmarket over the last few weeks makes very little difference to the case for long-term investing in shares.
So far, it’s a blip, I tell you.
In Theory:
Financial Instability Hypothesis and the fascinating concept of Ponzi finance
Philosopher trader Nassim Nicholas Taleb publishes his ten principles for a black swan proof world, aka Capitalism 2.0.
Steve LeCompte thinks Hyman Minsky’s Financial Instability Hypothesis is plausible. It challenges the view that the capitalist system constantly seeks equilibrium and proposes debt bubbles and Ponzi finance drive booms and busts.
The IMF goes in search of economies financed by Ponzi debt in Eastern Europe, and finds them.
Economist Paul Krugman says businesses will probably increase production later this year to replenish stocks. That won’t presage a true recovery though, unless sales increase too.
The Economist notes traders take riskier decisions when they’re stressed, and they’ve rarely been as stressed as they are now.
Celebrity economist Nouriel Roubini calls pantomime villain Jim Cramer a buffoon.
How big is huge? A Journalist regrets that numbers are becoming words.
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[...] As promised on Wednesday, from now on Monday’s a data rich day. First, off the market, and the bad news: It’s warmed up a tiny bit since I reported that the recent stock market ‘bounce’ was insignificant. [...]