Rudi's View | Sep 14 2011
(This story was sent in the form of an email two days ago to paying subscribers).
By Rudi Filapek-Vandyck, Editor FNArena
Equities are cheap. Price Earnings (P/E) ratios and Price-to-Book (P/B) valuations are well below levels seen over the past three decades, while corporate dividend yields either rival or exceed yields on government bonds and bank deposits, depending on which country we're focusing on.
Alas, history also shows us "valuation" is a relative concept and it won't necessarily stop share prices from falling.
In fact, the general consensus in Australia has been that the share market has been "cheap" ever since its first failed attempt to rally past the 5000 barrier post-GFC in April 2010. Yet, here we are, 16 months further and the index is close to a 1000 points lower, still looking wobbly.
Investors are being reminded that equities have invariably looked "expensive" and "cheap" at key turning points in the past, and both observations would not always have made for accurate signals about the intermediate way forward.
In hindsight, global equities looked pretty bloated in 1998 but who knew things would get a lot crazier still and it wasn't until March 2000 before the TMT-mania finally burst. Also, it can equally be argued equities didn't really sell off deeply enough in the bear market that followed, but less than four years later global equities were once again enjoying another steep uptrend.
In hindsight, equities really were too pricey by late 2007, yet history shows valuations were nowhere near previous bubble-peaks seen in 2000, 1965, 1929 or 1900.
History also shows that when it comes to valuations becoming cheaper, the current post-GFC de-rating can potentially stretch a lot deeper, still. Note, for example, share market valuations dived a lot deeper post 1965 and they didn't bottom out until 1982. These are the 18 years I often use as a reference point for today's situation. Share markets showed a lot of strength, and weakness, during those years, but each time both proved temporary at best and at the end of that period no net gains had been booked.
I guess the good news from all of this is that a continuation of the process of de-rating for equities post 2000 (not 2007) is that this doesn't necessarily mean share prices can only head lower from here. The de-rating that occurred between 1965 and 1982 pulled P/E ratios significantly lower than where they are today, yet price charts clearly show a sideways moving market, not one that imitates the Japanese market post 1989.
Similarly, while some ultra-bearish commentators continue to make references to the 1930s, the observation from 1965-1982 equally stands: P/Es fell much deeper, but, post the initial sharp sell-off in late 1929-1931, equities clearly traded sideways until the next bull market commenced in 1942.
Let's have a few charts to illustrate the above. Here's one chart I have used a lot post 2007, clearly distinguishing the times when equities are in an uptrend, otherwise referred to as "bull market", and times when this clearly is not the case (underlined in red):
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Here's the P/E de-rating that went on in the background behind all the daily price movements (chart from The Aden Report):
Closely analysing the second chart, I think there's one other observation that should have every investor's attention: history shows bull markets go hand in hand with rising P/E ratios, but also that P/E ratios first have to become really, really cheap before they embark on a sustainable uptrend.
If correct and if we assume history will be an accurate guide for the years ahead, this suggests we are still nowhere near completion of the post 2000 de-rating process. In other words: don't hold your breath for the next sustainable uptrend, it simply is too early for that.
A similar picture emerges when we look at other valuation methods, such as P/B and dividend yields. The Australian share market remains the dividend capital of the world with the ASX200 yielding around 5% on average, but Australian banks are offering more than 7% fully franked and there are quite a few industrial stocks that yield even more, such as beaten down retailers and media companies. The caveat is, however, these yields are never guaranteed and yields of 8% or more are more often than not a sign of elevated risks, not necessarily of market mispricings.
Internationally, average dividend yields are now higher than the yield on 10 year government bonds in all but one developed country -the US- but the global average still doesn't reach higher than 3%. In 2009 the global average dividend yield rose above 4%. In the seventies and eighties yields rose to between 5 and 6%.
Combining all of the above suggests the future "valuation" for global equities is very much dependent on earnings growth and here the signs might not be that favourable in the near term. Reading through international research, it would seem there are plenty of arguments in favour of another downturn in corporate profitability. From listed companies in China and other Asian emerging countries, to Europe, to the all-important US, companies are battling rising costs and unfavourable market dynamics, or so it appears, triggering concerns amongst securities analysts the world is about to face another period of downgrades to corporate earnings forecasts.
It is not difficult to see how this would impact on current "valuations", let alone on overall market sentiment.
Analysts at UBS formulated the problem as follows last week:
"Fundamentally, our greatest concerns reside with the level of expected earnings in coming years.
"Global earnings expectations have remained relatively stable despite weaker growth and financial market unrest. Forecast growth rates are around 14% globally for both 2011 and 2012.
"The upgrade-downgrade ratio for the World has moved slightly negative for the first time in this cycle. Even so, we appear to be in the very early stages of a downgrade cycle."
US corporates have in essence done a David Jones post the Lehman Brothers collapse: amidst a sharp deterioration in the overall economic environment, they slashed and burned costs and focused on efficiency, which helped restoring profit margins at peak levels. This also means US companies cannot employ similar tactic in case of another slump or downturn.
Investors in Australia know all too well what happened with David Jones's profits and its "valuation". Despite global financial troubles, and a severe slump in equity markets, David Jones continued improving its earnings per share from 22.68c in FY07 to 33c in FY10, while steadfastly lifting its dividends, but when retail spending faced another slump this year management simply could no longer cope. This admission caused a general de-rating for the shares.
David Jones shares traded at $5.50 in late 2007. They had re-gained that price level by late 2009. Today, they cost less than $3. The implied dividend yield has blown out to more than 10%.
Something to take into consideration, perhaps, is that in the absence of a strong rally later this year, 2011 is shaping up as a likely loss-year for the Australian share market. As the table below shows, two loss years in a row are a rather rare occurrence, though not unprecedented.
(The story above was originally written on Monday, 12th September 2011. It was sent out on that same day in the form of an email to paying subscribers.)
To subscribers who have been wondering why I haven't been writing my usual Rudi's View stories of late: I am simply too busy. This week won't see a Rudi's View story either as I will be preparing my presentation for Thursday on UNSW campus in Sydney (6-8pm, for those interested to attend).
Investors with a long term horizon and an appetite for equities might also want to read the following stories:
– How Not To Be Your Own Worst Enemy, 5 September 2011
– Gold And Dividends, 24 August 2011
– Dividends, The New Black, 22 June 2011
– Big Misunderstandings About… Dividend Investing, 18 April 2011
– A Tale To Remember, 28 February 2011
