Is anything a good buy at the moment?, asks breakingviews.com [via the WSJ]. Asset prices are determined by both liquidity and value and, in the past week, “liquidity considerations have predominated”, it notes. Ultimately, fundamental value should come through. But, unfortunately, even on this basis, “there isn’t much that looks cheap”, it concludes.
The FT’s John Authers, meanwhile, looks at the question of the moment in Thursday’s Short View column: is there a buying opportunity in stocks? “Many brokers say there is”, he says; “they argue that earnings are rising, while price/earnings ratios have fallen to their lowest levels in a decade. So, ‘buy when there’s blood on the streets’.”
Think twice before you try to “catch a falling knife”, advises Authers.
First, he says, “this decline is still nothing to write home about”. The S&P 500, the world’s most tracked index, was off on Wednesday about 8 per cent from its peak. “From 1996 to 2000, the end of the last big bull market, it had seven separate falls greater than this.”As bull markets progress, they become more volatile, so such corrections become sharper. So, looking at market patterns, it does not look as though there is enough blood on the streets yet.As for valuation, it is true that the historic p/e ratio on the S&P is at 16.46, almost at last July’s low of 16.35, which turned out to be a buying opportunity, and well below the average for the past five years of 21.8.
But it is misleading to look at valuation this way. Earnings are cyclical. So are the multiples investors will pay for them. If earnings are at the top of the cycle (as they are now), multiples should be lower.
If a cyclical adjustment is made by comparing stock prices with a rolling average of the past 10 years’ earnings, says Authers, “we get a cyclically adjusted p/e of 29.4″. This, he says, “is almost where it has been for four years, and much higher than its average of 24.56 for the past three decades, according to an FT analysis of Datastream data.”
It stood at 22.8 on the eve of the Black Monday crash in 1987, he notes.Over history, this measure identifies market peaks and troughs. It shows no compelling buying opportunity now. There are bargains out there for highly selective investors, but it is not yet time to buy the market as a whole.
Breakingviews, meanwhile, runs through the alternatives. Look first at credit, it says:
“It may seem that we’ve already had a return to normality after the heady conditions of recent years. Think again. At their narrowest, credit spreads on junk debt - as measured by the iTraxx Crossover index - were 1.8 percentage points. They are now 3.65. However, this type of lowly rated company over the longer term has suffered an annual default rate of 4.9 per cent, according to Moody’s. So there’s still plenty of scope for deterioration.”
Next, breakingviews looks at government bonds:
“At 5 per cent in the US and 4.4 per cent in the euro zone, 10-year government-bond yields are already geared to low inflation… Almost by definition, the next era won’t provide the same disinflationary boost. What’s more, the political balance favours bouts of higher inflation. After all, general price increases help out borrowers who got in over their heads when credit was easy.”
Say investors will need a 2.5 per cent real yield on risk-free government paper: “If one assumes that inflation will settle in around 3 per cent, bond yields should be more in the 5-6 per cent range,” it reckons.
Meanwhile, the real economy, “of course, is doing quite well - although troubles in US housing may yet hit growth there,” says breakingviews, citing Goldman Sachs’ estimates that the world economy will grow by 4.4 per cent in 2008. And profits in listed companies “look even more solid”: “They are expected to rise by 12.5 per cent in the US next year and by 10 per cent in Europe, according to Dresdner Kleinwort. So equities must be a buy, right?”
Well, says breakingviews, “superficially, they do look attractive”:
“Developed-world markets trade at 14 times expected 2008 earnings, according to Dresdner Kleinwort. Arguably, that’s cheap. It’s in line with very long-term average price/earnings ratios but low if one takes the last 25 years.”
However, we are probably near a “cyclical peak on profits”, warns breakingviews. “What’s more, equities have benefited from easy credit in many ways. The financial sector, about a quarter of the developed world’s market capitalisation, has profited directly. Commodity producers, an additional 18 per cent of the total, have gained more indirectly, from the ability of customers to bid up the prices of oil and metals to highly profitable levels. Add in utilities that have benefited from the regulators’ slow catch-up with declining finance costs, and about half the market would have a big profit markdown in a less financially accommodating world.”
The damage, though, is likely to be spread even wider, warns breakingviews. “Any company that is a net debtor - and that includes almost all quoted companies - faces some sort of profit markdown. Not only will wider credit spreads push up interest costs, but companies will want to have less debt and larger cash cushions if they are less certain about the availability of liquidity.”
The “best conclusion”, according to breakingviews, “is that shares are now a better deal than bonds or credit - but no better than fairly valued.”
Commodities, meanwhile - “one of the best investments in the recent bull market - belong in what breakingviews calls “the dubious investment category of income-free assets”: “They may look appealing when investors are hugely optimistic and money flows freely. But many commodities, such as oil and copper, trade at roughly twice the cost of production. If credit is scarcer, they could come down with a bump.”
After a bull market, “there is a big psychological adjustment to be made”, concludes breakingviews. “Once investors get their minds round the fact that future returns will be a lot lower than those of the recent past, they’ll start to spot bargains again.”