There seems to be growing support for the notion that equities have reached fair value. This raises two questions: how far it is true, and how far it is useful.
As to the latter, I described a month ago how the UK consultant Andrew Smithers, drawing on work by the US academic Robert Shiller, concluded the US market was fairly valued with the S & P 500 at 880 – roughly its level today. But as Mr Smithers also found, previous serious market collapses did not end until they were, on average, at only half fair value.
This is unsurprising. If markets never undershot, they would never overshoot either. The more depressing conclusion is that when equities are merely fairly priced, no one can afford to buy them – barring lone individualists such as Warren Buffett.
This is especially true today. Hedge funds, already faced with investors’ cash flooding out of the door, cannot buy for fear of further losses.
Supposed long-term investors such as pension funds and life companies are nothing of the kind, if only because regulation now obliges them to mark their short-term losses to market.
As today’s succinct cliché has it, early is the new wrong. This means the notion of efficient markets is simply risible. Then again, most of us knew that already.
But are we sure equities are indeed fairly priced? The Shiller method, which takes today’s price as a multiple of 10-year inflation-adjusted earnings and compares the result with the long-run average, says so. I am not saying that is wrong, but I have reservations.
The strategist James Montier of Société Générale, who otherwise buys the fair-value argument, points to a set of criteria drawn up by the investment authority Benjamin Graham – a veteran of the 1930s – on how to recognise value opportunities.
These range from yields and earnings multiples to balance-sheet strength and the earnings record. Mr Montier has screened for global stocks meeting the requirements. He found some small-capitalisation stocks – but no large ones.
Again, strategists point to the fact that in both the UK and US, the yield on stocks is now persistently higher than the yield on government bonds for the first time in half a century.
Citigroup argues this either means investors expect earnings to fall to an improbable extent, or the relationship between bond and equity yields is broken.
The improbability is open to argument. Citi expects a fall in corporate earnings, from peak to trough, of 40 per cent – the same as in the early 1990s.
This is suggestive. In the credit markets, too, it is argued that securities are priced on improbably disastrous outcomes. In some cases, that is no doubt true.
But the Bank of England, for instance, in its latest Financial Stability Report, argues in effect that prime UK residential mortgage-backed securities are under-priced on a worst-case scenario. But that scenario envisages mortgage arrears rising to only three-quarters of the level seen – again – in the early 1990s.
All this is rather at odds with the US Treasury Secretary’s reference last week to “a historic situation that happens once or twice in 100 years”, or his UK counterpart’s remark that we now face uncertainty “not seen in a generation”.
Granted, both were justifying huge increases in government spending. But if forecasters really believe the contraction of the early 1990s represents the limits of the possible, they should perhaps get out more.
As to whether the relationship between bond and equity yields is broken, this is not a simple question. Ever since 1959, in the US and UK, Treasury yields have been higher than equity yields – until the past few weeks, that is. But before that, it was the other way round.
The odd thing is that nobody seems quite sure why the change took place. Or more precisely, there are plenty of theories, none of which I find persuasive.
But I do not conclude that the model is necessarily broken. The recent crossover may simply result from investors taking a more bearish view on the dividend outlook than strategists do. In the UK, certainly, the likely suspension of bank dividends is a heavy blow.
But there is a wider issue here. Too many of today’s bullish arguments suffer from a lack of imagination – an inability to judge the future in terms of anything but the fairly recent past.
One final thought on this. Morgan Stanley has just produced a piece declaring that the present downturn is “neither the Great Depression or Japan”. The argument boils down to saying that all previous policy mistakes have been avoided this time.
But that, of course, carries a hidden premise: that all possible mistakes were contained in those two episodes. That is, none of today’s policy actions will turn out later to have been blunders.
Any takers on that one?
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