The great value divide
Posted on December 12, 2008 by Richard Beddard
Filed Under Editor's choice, Investing, Markets |
The market’s reasonably priced for a change, but should investors wait until it gets ludicrously cheap?
Students of the market are tripping over themselves touting obscure measures of value, while erstwhile bears are suddenly bullish.
That’s because after decades of excessive prices the market has fallen to something like fair value. Fair, that is, relative to the average of a decade or so of profits, and to how much the assets of the companies in the stockmarket are actually worth.
If shares in general aren’t too expensive, then some will be utter bargains. James Montier, a strategist at Société Générale who’s spent most of this decade swatting fellow analysts with bearish reports, has never been more bullish. One of his charts shows the UK market on a cyclically adjusted Price Earnings ratio of about 12, as low as it’s been since the early 1980’s:
Montier says:
From a bottom-up perspective, the equity market is offering some excellent companies at truly bargain prices for those with the fortitude to shut their eyes, or at least switch off their screens and buy.
Dr Keith Anderson also tracks a cyclically adjusted Price Earnings ratio. Although his number is different, because he only averages the earnings of UK companies with eight unbroken years of profits, it tells a similar story:
Keith says:
One very interesting thing is that the average 8-year P/E for all companies is now 5.9. The nearest comparable market-wide PE8s were 9 or 10 in 1975-80, and 8.4 in 2003, just after the nadir of the market before they invaded Iraq…What we now have is an unprecedented buying opportunity, the like of which we shall not see again in our lifetimes. Or at least, not until February 2009 when I calculate it again.
Jeremy Grantham, who for years has predicted the market will crash, is trickling money back into stocks. In his first appearance on TV in November, he said:
For the first time in twenty years, global equities are reasonably cheap.
Tobin’s Q, the ratio that compares market value and the replacement cost of assets, draws a very similar chart. In November, it hit its average, also for the first time since the 1980s:
This chart, from Smithers & Co, shows the cyclically adjusted PE (CAPE), and Q. Smithers also maintains a Q FAQ, and here’s an explanation of Q from Interactive Investor’s Peter Temple.
Although James Montier, Keith Anderson, and Jeremy Grantham feel confident cherry picking bargain shares with the market at these levels, buying the market might not be such a good idea. Bill Gross, managing director at PIMCO says the cyclically adjusted PE is a backward looking measure and the future won’t be the same:
… Stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner.
When it comes to predicting the market he’s a little vague but I don’t think Professor Robert Shiller, whose cyclically adjusted PE Mr Gross uses, is confident low PEs mean higher stockmarkets in future. Looking a decade ahead, he told me in an iBall interview a couple of weeks ago:
We are in the most severe financial crisis since the great depression, so I wouldn’t be confident in forecasting increases in the market. In fact, I would say offsetting that there is the possibility of a massive overshooting on the way down. And the way confidence has evaporated recently, and parallels with the other big episode of the Great Depression suggests that there is, I think, downside risk that really can’t be discounted now.
Like Bill Gross, Russell Napier’s been looking at Q, but unlike Mr Gross he doesn’t hedge his bets. On Bloomberg, he sounds even gloomier than Professor Shiller:
The Q has come down to its average, however it’s not always stopped at the average… It has tended to go significantly below that in long bear markets.
Apparently Mr Napier, who wrote the book on bear markets, believes the US S&P 500 could fall 55% from current levels by 2014. In 1921, 1932, 1939 and 1982, the bottoms of the last four great bear markets, Q fell to 0.3. At its peak in 1999, Q was 2.9. Now it’s 0.7, so it still has some way to go if history is to repeat itself.
Our newly converted bulls, Messrs Grantham, Montier and Anderson, are well aware that just because stocks are fairly priced, it’s no guarantee they won’t keep falling until they’re dirt-cheap:
Will I be early?
Asks Mr Montier in a recent report, before he answers:
Almost certainly yes, but if I can find assets with attractive returns and I have a long time horizon I would be mad to turn them down. As Jeremy Grantham said in his Q3 letter “If stocks are attractive and you don’t buy and they run away, you don’t just look like an idiot, you are an idiot”.
But, being value investors, they’re picking specific stocks below fair value*1, not the whole market at fair value.
Footnotes
- Curiously, not the same ones. Mr Grantham likes US blue chips and emerging markets while Mr Montier prefers beaten up shares on very low valuations. He thinks emerging markets are still overvalued.
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2 Responses to “The great value divide”
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Hi Richard,
That was a very good article, bringing together some good opinions and reasonable caveats.
I am concerned about blindly using a 10 year earnings cycle as representative of what is likely to happen in the future after looking at some S & P I calculated numbers below (and I make no guarantees on their accuracy, DYOR).
For the S & P 500 the average 10 year reported earnings between June 2008 and Sept 1998 was about $52/share.
The actual reported earnings in the last quarter (between June 2008 and Sept 2008) was about $40/share.
At the current S & P price of about 900 this gives the following PE’s
10 years until June this gives 900 / 52 = 17
Between June and Sept gives 900 / 40 = 22
The simple average of PE’s over the last 10 years is about 26. Therefore both 17 and 22 seem distinctly undervalued on a 10 year basis. Earnings would need to decline by 15% in order to make the current price of 900 give a PE of 26.
However, it does seem likely that earnings will decline by 15% in the final quarter so the current price is about right on that basis. It is hard to say what will happen after that.
However (again), I think it is interesting to note that the last 5 years of earnings tell a very different picture. And it looks like the Fed is determined to replicate this with their current ‘policies’ whatever the cost. Over 5 years, the average reported PE is only 20 and the average ‘leveraged’ based earnings is $64/share.
Therefore you have to somehow reconcile a current earnings of $40/share (and likely to decline further) versus a target earnings of $64/share and still only expect to get a PE of 20!
The big difference between now and 2003 is that consumers (who basically drive company profits) have not had time to de-leverage their debt yet! What on earth is the Fed thinking of with zero % interest rates!!! I thought their policies were meant to help their tax payers, not drive them into the dirt.
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