FYI | Nov 05 2008
By Chris Shaw
According to analysis of investment research and trading firm State Street Global Markets the decline in global equity markets since October of last year is among the worst in the last forty years, but even allowing for this, the P/E (price to earnings ratio) multiple for US equities derived from reported earnings is still higher than its average of the past 147 years.
Using reported earnings gives somewhat misleading answers though, as the group notes by adjusting earnings for leverage and by relating underlying earnings growth to changes in GDP State Street estimates the US P/E multiple is currently about 26% below its long-term average.
Such a divergence from the average has only been seen in periods of great distress such as during the Great Depression and World War II, which suggests US equities are currently cheap for those investors with a longer-term view. While data are not available for such a long period for global equities the group has run a similar comparison using the MSCI Index and data from 1970 and this suggests global equities are also cheap at present. State Street estimates current levels are around 39% below their long-term average.
But valuations tell only part of the story and as the group points out, valuations certainly don’t indicate when the next rally may take place. At present State Street takes the view the high level of volatility on global markets is keeping many investors on the sidelines, especially the professionals.
And it is these investors that are seen as the key. State Street notes institutional investors now account for around 76% of the equity of US corporations, up from around 6% in 1946. This means any serious rally is going to require money to come into the market from these professional players. So far, the group notes, fund flows suggest this is not yet occurring in any significant way.
The point where this occurs may mark the turning point for the market in the group’s view, it just hasn’t been reached yet as the professionals continue to lower their equity exposure in expectation of a continuation of the global economic slowdown into 2009.
According to group macro strategist Mr Carlin Doyle a part of this reduction in equity exposure is being achieved by investors going more risk averse and this means equities in emerging markets are being sold as they offer higher risk given expectations for below average growth expectations for the world economy.
At the same time Carlin expects this flight to quality to provide support for the US dollar, which should mean the end to the greenback’s multi-year downtrend as re-coupling rather than de-coupling from the US economy returns to favour.
Also supportive for the US dollar is the reversal in commodity markets, as this signals an easing in inflationary pressures, which in turn implies further falls in interest rates globally. Here the greenback is a beneficiary, as the US Federal Reserve is near the end of its easing cycle, while other currencies and economies have further to go in this regard, making the US dollar relatively more attractive over time.
While such an environment is supportive for the US dollar Carlin expects it will place commodity currencies such as the Australian and New Zealand dollars and the South African rand under further pressure, while the shift to risk averse currencies should also prove to be beneficial for the Japanese yen in his view.
