The great crash of 2009 revisited
Posted on February 18, 2008 by Richard Beddard
Filed Under Markets |
Last year I wrote a blog that, tongue in cheek, predicted the Great Crash of 2009. At the time, I was researching bearish ideas to test the arguments of Ken Fisher.
Last month James Montier, author of Behavioural Investing and an analyst at Societe Generale, published a report on stockmarket valuations. Valuations matter because, although markets can be ‘cheap’ or ‘expensive’ for years, ultimately they return to average levels. Knowing the market’s current valuation can help us imagine what might happen in future.
James’ measure for value is the Graham and Dodd PE, which regular readers of this blog will know. It’s the long-term price earnings ratio I’ve used to assess individual companies, but applied to the whole market. In other words, the price of an index divided by the average earnings of all the companies in it, averaged over a period of at least five years.
Ten years is better, and prevent a few good years, or a few bad years of corporate profits from distorting the ratio.
This chart, taken from the report, shows the 10 year PE for the S&P 500, the largest 500 stocks listed in the US:
Far from being cheap, he observes:
US equities are currently about as expensive as they have been anytime since 1929 (excluding the dotcom mania).
He also rubbishes the bulls’ favoured valuation method, the relationship between earnings yields and bond yields.
The earnings yield for a company or the market is the inverse of its price earnings ratio (literally earnings per share divided by price). Since earnings (or profits) are the shareholders’ reward for investing in a company, the earnings yield is like an interest rate we can compare to bonds yields.
In theory, when earnings yields are higher than bond yields, as they are now, money will flow from low yielding bonds into high yielding shares. Relatively speaking, shares are cheap.
While James agrees the Bond Equity Earnings Ratio (BEER) is at a twenty-five year low, he says it’s irrelevant because bonds can remain attractive even if equities are cheaper:
The root of the problem with the BEER is that it compares a nominal asset (bonds) with a real asset (equities). Nominal assets are exposed to the ravages of inflation but benefit from deflation. Real assets find themselves in the reverse position. Thus the relationship between bonds and equities is likely to be driven by the inflation environment that dominates.
The final nail in the coffin for those who are advocating blind faith in the BEER is the evidence from Japan. Supposedly ‘cheap’ equities have done pretty much nothing except get cheaper relative to ‘expensive’ bonds.
That observation is worrying because, following Ken Fisher’s lead, I’ve been quoting the gap between the global bond yield and the global earnings yield as a measure of the market’s health.
Recent market turmoil hasn’t turned Ken. He was as bullish as ever in an exclusive interview on iBall on Friday.
Fisher Investments tells me, the gap between the global bond yield (3.6%) and the global earnings yield (7.8%) is about 4.2%. That’s much wider than when I asked about it last year, and likely to fuel ‘equity supply destruction‘ - where chief executives and corporate financiers seize on cheap debt to buy back shares or buy whole companies. It’s a fundamental economic concept, it says, that:
…when the supply of something shrinks, prices rise.
The supply of equity is shrinking, says Fisher, quoting near record levels of buy-backs and mergers and acquisitions for cash. Giants like Rio Tinto and Microsoft can borrow more relative to their size than before. Despite the general perception of a credit crunch, only the spivvy end of the market is affected:
Credit is exceedingly cheap for pretty much everyone today—in fact, borrowing rates are cheaper today than a year ago, unless you’re a junk-rated firm.
I can’t reconcile these opposing views of market dynamics but, in one way, it’s easy to reconcile James and Ken’s opposing views on the direction of the markets.
James says, the high price of stockmarkets relative to average earnings doesn’t necessarily auger collapse in the short-term:
Of course valuations aren’t a determinant of short-term returns. But they are the primary determinant of long-term returns.
And Ken says the short-term is all that matters:
I never have a long view… What would I do about 2009 right now anyway if I knew?
So they could both be right. The outlook for the market could be positive in the short-term, and negative in the long-term. Take another look at the chart. The market can clearly be expensive for years - the Graham & Dodd PE has been higher than average since the mid nineties. There’s nothing about a high market PE that heralds imminent falls in the stock market.
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9 Responses to “The great crash of 2009 revisited”
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Is this the next bubble? Stocks get bought back, prices rise, people get on the wagon, prices rise, more stock gets bought back, until we have the next bubble. Cheap credit seems just too destructive all round.
Hi Rob
That’s a very good question! From my conversations with Ken in the past I think he’d say it’s the next phase of the bull market. It’s not the next bubble because bubbles aren’t rational. The mechanism by which companies buy up their own stock, or that of other companies is rational. They’re just profiting from the difference between the cost of equity and the cost of debt.
Just as an example of just how cheap debt is According to Alphaville (http://ftalphaville.ft.com/blog/2008/02/21/11083/porsche-capital/ ) Porshche is investing 10b euros it borrowed to fend off a takeover approach because the returns fro m ‘low-risk’ investments are higher than the cost of the debt.
Hi Richard,
This is a really great blog entry. Many thanks.
I enjoyed watching the Ken Fisher interview on iBall. He is very persuasive in person and he has actually provided some new viewpoints which are not in his book (for once :-))
He is very persuasive but he has not actually said that 2009 is going to be good or bad. While he makes lots of arguments to say why it is not necessarily going to be down, he did not actually make a strong case for it going to be up either.
I am happy to wait this one out, to be honest. There is a huge amount of cash sitting around out there, and the Americans are printing loads more of it and the cash rich countries are spending it. At some point, there is going to be some sectors which start to do well from this. There are already signs that sector performance is shifting around.
The most interesting observation (I do not know if it is true or not)
“When a big category blows apart (i.e. financials), as a category, it does not lead the market for many years”. Is the same true of commercial property I wonder?
Hi Robin,
Thanks for your comments. Well, as you know, I’m agnostic. Though Ken’s definitely still bullish (we ask him outright in the video - Surely you’re not still bullish and he says Oh yes I am!). Also check his columns.
Good point about commercial property. This is psychology at work isn’t it. Commercial property could be cheap now, so could cyclicals like recruitment agencies which have taken a hammering. But that doesn’t mean investors will pile in because:
a. They’re scared economic conditions might worsen even more than people think.
b. They’ve probably lost money in these sectors so they’re pretty much repulsed by them.
That’s why value investing is a long-term game - if you get in too early you’re fighting the momentum, and the momentum is down. It may not be rational, but it’s real!
There was an interesting observation from John Authors (recently writing in the FT) about rational investors. In EMT, we assume that a rational investor is one who assumes that there is no momentum (or inertia) in the markets. However John Author’s has pointed out that most hedge funds and institutional investors will invest using momentum ideas. This makes momentum investing a self-fulfilling prophecy. Therefore, what is more rational? Someone who assumes that there is no momentum or someone who assumes that there is?
On another note, in today’s FT there was an article about how private equity companies are starting to get financing from small local banks as the big banks are all locked up. It seems the stock market always finds a way to keep going
Very interesting comment Robin. I think rational investors acknowledge there is momentum in markets but the momentum itself isn’t rational
Value and ‘momentum’ are two sides of the same coin. Value appears when there is negative momentum and prices are pushed to irrational lows.
The fact that those lows are irrational, or that prices pushed to new highs by hype and hysteria are also irrational gives stockpickers (and, I suppose, market timers) their opportunity.
What about other investment opportunities? While gold and perhaps oil are close to a peak, foodstuffs; especially those which are double up as candidates for the current bio-fuel market look capable of competing for a good deal of any liquidity. They represent a big market after all in which demand is clearly outstripping supply.
That would leave you in the grain fields of africa. The world cannot afford to indulge Mugabe any longer!