Tuesday, October 27, 2009

Are The Markets Overvalued?

GLOBAL stock markets have recovered sharply from their bottom in March 2009. Where will our markets go from here?

To answer this question, we have to consider the prospects of the US market as the correlation between the US and world stock markets is very high especially when major movements occur in the US stock market.

In fact, emerging markets normally exhibit higher beta, moving up more than the US markets in a recovery and falling by more in a downturn.

The price-earnings ratio (PER) of the US market has ranged from a recent low of 6.6 times during the deep recession in July 1982 to over 40 times during the tech bubble in 1999.

The PER of the US market (as measured by the Standard & Poor’s 500 Index) was 22 times when the Dow peaked at 14,164.5 points on Oct 9, 2007, compared with an average 14.6 times from 1895 to 1995, according to Professor J Shiller (see chart).

Shiller’s data also shows that for that period, the market traded between 10 and 20 times earnings for 70% of the time.

According to consensus forecast, the S&P 500 which comprise 500 of the larger stocks in the US (rather than just 30 stocks for the Dow) is trading on a current PER of around 20 times, implying that the market is trading at close to the upper end of its normal trading range.

Does this imply an imminent correction?

The PER of the market cannot be viewed in isolation. Other factors like interest rates, inflation rates, earnings growth and human psychology have to be considered.

Market PERs are normally higher when inflation and interest rates are low.

Low deposit rates will make stocks more attractive as dividend yields of stocks could be higher than deposit rates; and stocks, if chosen well, could provide earnings growth which could boost future dividends.

The PER of the stock market was below 10 times in the early 1980s when inflation and interest rates were high.

The then Fed chairman Paul Volcker, who successfully tamed inflation with a tight monetary policy in the early 1980s, set the stage for falling interest rates and one of the longest bull run from 1982 until the bursting of the tech bubble in early 2000.

With the Fed slashing interest rates to almost zero following the global crisis precipitated by the collapse of Lehman in September 2008, the attractiveness of equities has improved versus bank deposits which pay pitiful interest rates.

Third quarter earnings of US companies have generally outperformed analysts’ forecast with 79% of the S&P 500 companies posting results that exceeded estimates.

Revenues have been lacklustre and earnings have been achieved in part from cost cutting and from a weaker US dollar which has boosted revenues for US multinationals.

More than half of the earnings of US multinationals are denominated in foreign currencies which have appreciated against the US dollar.

The Japanese market peaked at almost 39,000 in 1989 and was then trading on a PE of over 70 times.

Such high PERS cannot be justified or sustained for long and the Japanese market is currently trading at less than a third of its peak value.

The difference between the US and Japanese stock markets is that the US markets were less overvalued when the economic and stock market crash happened in September 2008.

The Dow has surpassed 10,000 points and has recovered almost 50% of the 7,617 points it lost between the peak of 14,164.5 points on Sept 10, 2007 and the bottom at 6,547.1 points on March 9, 2009.

Economic recovery remains weak and hence the excess liquidity resulting from lower interest rates and printing money is finding its way into financial markets (especially stocks and commodities) and properties.

A double dip into a deep recession is unlikely as house prices in US and many other countries have started to recover thereby boosting consumer confidence and bank profits through write-backs and higher valuation of mortgage-backed securities.

A more likely scenario is a lacklustre recovery, dampened by weak consumer spending as US consumers deleverage.

At these levels, the US markets seem to be fairly valued.

Any significant move up may push the US markets into bubble territory, a possibility that cannot be ruled out as central banks and pump-priming politicians are only likely to act when the bubble is obvious.

After all, who wants to spoil a good time that wins votes.

At these levels, investors will have to be more cautious.

Stocks with a high dividend yields that can be sustained offer some protection as investors are seeking yields in a low interest environment.

This would include the utility, telecommunication and food sectors.

The gaming, tobacco and alcoholic beverage sectors should also see stable demand, that is if they are not subject to large excise duty or tax increases in the budget.

Those seeking growth should ensure that the companies’ PER are reasonable and growth can be sustained in a competitive environment where excess capacity may encourage price dumping.

The rubber glove companies in Malaysia have pricing power as they produce 60% of the world’s rubber gloves and sell to the healthcare industry where demand is steadily growing.

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