Sunday, January 10, 2010 0 comments ++[ CLICK TO COMMENT ]++

Where are we?

I ran across a great article in The Economist summarizing the current state of asset markets. Nothing earth-shattering in the article but it does summarize various issues and examines potential bubbles. As the year just started, investors are probably thinking about the same issues so I thought I would quote some key points from that article.

THE opening of the Burj Khalifa, the world’s tallest building, in Dubai on January 4th had symbolic as well as architectural significance. Skyscrapers have long been associated with the ends of financial booms. The Empire State Building opened in 1931, two years after the Wall Street crash. The Petronas towers in Kuala Lumpur were unveiled in 1998, in the depths of the Asian crisis. Such towers are commissioned when money is cheap and optimism about economic growth is at its height; they are often finished when the champagne has gone flat.

The past three decades have been good for skyscraper-building. The cost of borrowing money, in nominal terms, has fallen sharply (see chart 1).

Small wonder that one bubble after another has appeared in financial markets, with the subjects of investors’ dreams ranging from emerging markets and technology stocks in the 1990s to residential housing in the decade just ended. Nor is it surprising, with money so cheap, that consumers and companies have indulged in regular borrowing sprees.

It is absolutely critical to keep in mind that the bond yield drives assets. This may not be the case in the short run but it is certainly the case in the long run. The Economist plots the SDR interest rate—this is the first time I've encountered this—which describes the cost of borrowing for the world.

Even if you are not a bond investor or a businessperson borrowing money, one of the key decisions you will have to make is whether yields are going to rise, fall, or remain whether they are. The ultimate value of an asset will depend heavily on this.

The Stock Market, You Say?

Most people reading this invest primarily in stocks so how does the stock market look?

Well, as usual, it depends on the measures you use and your future outlook. People like me felt that the stock market was not cheap even during trough early last year—a view I still maintain—whereas others, including Warren Buffett, felt it was attractive. The current situation is just like early last year. There is no obvious top or bottom. The Economist has this to say:

As further evidence that there is no bubble, bulls point to the relatively modest level of prospective price-earnings ratios; the MSCI world index is trading on a multiple of 14 based on prospective earnings in 2010, according to Société Générale, around the long-term average. However, prospective multiples can be very dependent on the optimism of the analysts who make the forecasts—and such analysts are in the business of selling shares.

A better long-term measure is the cyclically adjusted price-earnings ratio, which averages profits over the previous ten years (see chart 2).



On this measure, valuations are nowhere near the 2000 peak. They are, however, still pretty high by historical standards; Smithers & Co, a firm of consultants, reckons they are nearly 50% above their long-term average. Even now, after a dismal decade for shares, Wall Street is offering a dividend yield of only just over 2%, compared with a long-term average of 4.5%.

Most readers of this blog would be familiar with the CAPE (cyclically adjusted P/E ratio, aka Graham-Dodd 10 year P/E ratio) since that is my favourite valuation metric. One obviously can't time things based on that but it does provide an overall measure of the market. Based on the CAPE, the market, at least the US one, is nowhere near cheap.

As mentioned above, one has to discount interest rates. Presently the rates are lower than in many prior eras so the current CAPE of around 20 isn't as bad as it looks. Nevertheless, I am not comfortable deploying capital. I have to think more, given my personal job situation, but my feeling is that I will pursue the path of the last few years. Namely, I will likely invest most of my money in investment strategies with low correlation to the market or the economy (such as risk arbitrage and liquidations.) Such strategies tend to underperform when the markets rally strongly (like last year) but tend to outperform when the market does poorly (like two years ago.) Of course, if I find a good business at great prices, it's worth investing heavily regardless of the macro outlook.

Home Sweet Home

Housing is very important even if you don't invest in it. This is because something like 60% of residential real estate is owned by the bottom 50% of the population (in contrast, roughly 90% of the stock market is owned by the top 20%.) If there is a housing bust, the economy is almost always negatively impacted on a grand scale. The stock market, in contrast, may not impact the economy very much (for example, the 2000-2002 stock market crash was one of the largest in history but the US economy had one of the mildest recessions ever—if you were outside the technology industry, you probably didn't even feel anything; 9/11 terrorist attacks probably had a bigger impact on the econmy than the dot-com bust.)

Housing is complicated to analyze (partly because it is localized and depends on local/regional laws) but the measure that approximates the P/E ratio for stocks is the home price to rent ratio. The Economist says the following for a similar measure:

In housing, a measure based on rents shows that American prices are back to fair value but prices in Britain, France, Spain and Australia are all 30-50% above their historic averages. Low mortgage rates (and government schemes to head off foreclosures) have stopped prices falling to the lows of previous downturns.

Similar to how the low bond yields makes stocks less overvalued than it appears, the low mortgage rates makes housing less overvalued than it otherwise would be.

It's surprising to read that places like Britain and Spain are above their historic average while America is close to the average. Canada, from what I see—I don't follow the Canadian market much even though I live here—looks overvalued to me. Canada, like Australia, didn't really see a crash of any sort.

If the conclusions cited by The Economist are correct, America is far ahead of many other developed countries when it comes to the housing bust. Based on what I'm reading here, it's probable that the GSEs—Fannie Mae and Freddie Mac—will stop absorbing losses in the future. They have no reason to be cushioning the real estate bust if home prices are close to the long-term average.

How About Emerging Markets?

Emerging markets, particularly China, are highly vulnerable to bubbles. In fact, bears like me think there are already bubbles. The Economist points out that there are valid reasons for the strong growth—asset markets catching up to the growth of the ecoomies—but also cites some concerns:

This optimism explains why emerging markets now trade at a premium (measured by the ratio of market prices to the accounting value of assets) over developed markets. In the past, such premiums have usually presaged a setback.

In addition, emerging markets are seeing much faster credit growth than their developed rivals. In China, for example, broad-money growth in the 12 months to November was almost 30%. Such growth is the logical result of pegging a currency to the dollar, and thus importing a monetary policy which may be right for America but which is too loose for the fast-growing Chinese economy. Some of that credit growth is leaking into asset markets.

The first point is a very dangerous sign in my opinion. Emerging markets, as a whole, should not trade at a premium to developed markets! Although growth rates are better, their lack of property rights, proper accounting and regulatory standards, political risk far outweigh the growth prospects—at least I think so.

Got Gold?

Another area where a bubble might be developing is in gold. Gold is an unlikely cause of euphoria, given that investors use it as a bolthole when they worry about inflation, currency depreciation or financial chaos. But the metal has seen a speculative peak before, most notably in 1980, when its price touched $835 an ounce, before losing two-thirds of its nominal value over the next 20 years.

The main rationale for buying gold at the moment is that, in the face of the credit crunch, most governments would like to see their currencies depreciate to boost their exports. If paper money is being “debased”, that is bullish for gold, an asset that central banks cannot create more of and that is no one else’s liability.

The gold bugs may be right. But the price has already quadrupled from its low and suffers from no real valuation constraints; it has no yield or earnings against which to measure it, so it is hard to say when it is “expensive”. Dylan Grice, an analyst at Société Générale, has mischievously suggested that, if the Bretton Woods system (under which the Fed was obliged to exchange its stock of dollars for gold with other central banks) were operating today, bullion would trade at $6,300 an ounce.

I am not a fan of gold at these prices. It is definitely not a contrarian asset given how it has gone up 9 years in a row. Gold investors may be in for the roller-coaster ride of their life this year.


Anyway that summarizes the current state of several key assets. Although I have been wrong with many of my macro calls—I'll go over them in the next few weeks—I'm largely sticking with my stance from last year. In particular, watch out for any serious problems emnating from China.

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