Stocks and risky assets stumble

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I concluded a post on stock markets over the weekend saying: “After equities’ seven-month climb, stock markets certainly look vulnerable for a decline. Two downside reversal days – on Wednesday and Friday – would seem to indicate that stocks could commence a pullback to work off the overbought condition, allowing fundamentals to reassert themselves.”

Global stock markets, as well as other risky assets, closed sharply lower over the past few days as concerns mounted over the sustainability of the global economic recovery and the outlook for central bank policy.

The performance of the major asset classes is summarized by the charts below, with the top one showing the period from the March 9 stock market lows until October 19 peak and the second one the subsequent period. The numbers indicate an all-change pattern in the performances as risk aversion re-entered financial markets and government bonds and the US dollar regained some favor.

grafiek1

Source: StockCharts.com

grafiek2

Source: StockCharts.com

A summary of the movements of major global stock markets since the March 19 peak, as well as various other measurement periods, is given in the table below.

The MSCI World Index and the MSCI Emerging Markets Index have declined by 5.3% and 6.2% respectively since the highs of October 19, with markets like Ireland (‑13.2%), Brazil (-10.5%), Austria (-10.8%) and Belgium (-9.0%) falling by significantly more. Also, higher risk indices such as small caps have borne the brunt of the selling, with the Russell 2000 Index down by 9.0%. This is a pattern that one would expect as investors shift the emphasis to higher quality.

Click here or on the table below for a larger image.

tabel-s

The major moving-average levels for the benchmark US indices, the BRIC countries and South Africa (where I am based) are given in the table below. A number of indices, including the S&P 500 Index, have fallen below their 50-day moving averages over the past few days, but all the indices are still holding above their respective 200-day moving averages. The 50-day lines are also above the 200-day lines in all instances.

The October lows are also given in the table as a break below these levels would indicate a reversal of the uptrend since March, i.e. reversing the progression of higher reaction lows.

Click here or on the table below for a larger image.

chartlevelsmall

Over the past few days a number of commentators have made pronouncements about the extent of a possible decline. For example, Jeremy Grantham (GMO) expects the S&P 500 to drop by 15% to 25%, David Rosenberg (Gluskin Sheff & Associates) sees markets falling by 20% and Doug Kass is looking at -5% to -12%.

This brings me to the topic of valuations. Based on operating earnings (i.e. stripping out everything that is bad), the historical price/earnings (PE) multiple of the S&P 500 is 27.0; using “as reported” (GAAP) earnings the figure shoots up to a giddy 95.7! Getting past the loss-making fourth quarter of 2008 and calculating prospective multiples through December 31, 2009 reduce the valuations to 19.0 and 24.4 respectively. Looking further out to the end of 2010, the prospective PEs are 14.1 and 22.9 respectively – still hardly the type of valuations that will inspire one to be a buyer across the board. (The earnings estimates are courtesy of Standard & Poor’s.)

Another way of looking at valuation levels, and cutting through the uncertainty of having to forecast earnings, is by means of Robert Shiller‘s cyclically adjusted price-earnings ratio (CAPE), effectively muting the impact of the business cycle by averaging ten years of earnings. Using rolling ten-year reported earnings, my research (based on Shiller’s methodology, but including some refinements) shows that the “normalized” price-earnings ratio of the S&P 500 Index is currently 18.7. This compares with a long-term average of just more than 16.3 and implies an overvaluation of 15%. Considering a geometric rather than an arithmetic average of earnings, the overvaluation increases to 25%. The graphs below show data since 1950, but the actual calculations date back to 1871

sp1

sp2

Meanwhile, David Rosenberg highlights that this is not the onset of a sustainable secular bull market as we had coming off the fundamental lows of prior bear phases, such as August 1982, when:

• Dividend yields were 6%, not sub-2%.

• Price-to-earnings multiples were 8x, not 27x.

• The market traded at book value, not more than twice book.

• Inflation and bond yields were in double digits and headed down in the future, not near-zero and only headed higher.

• The stock market competed with 18% cash rates, not zero, and as such had a much higher hurdle to clear.

• Sentiment was universally bearish; hardly the case today.

• Global trade flows were in the process of accelerating as barriers were taken down; today, we are seeing trade flows recede as frictions, disputes and tariffs become the order of the day.

• A Reagan-led movement was afoot to reduce the role of government with attendant productivity gains in the future, as opposed to the infiltration by the public sector into the capital markets, union sector, economy and of course, the realm of CEO compensation.

Back to charting, Adam Hewison (INO.com) also sounded a cautious note on the outlook for the S&P 500 as explained in one of his popular technical analysis presentations. Click here to access the presentation.

I conclude with a comment from David Fuller (Fullermoney) who said: “At this stage of the bull cycle, I think a correction of approximately 10-15% for developed country stock markets and somewhat more for emerging markets would be good news for investors with cash to invest. Such a mean reversion towards rising 200-day moving averages would blow the recent froth off valuations and stem talk of an early change in monetary policy.”

I will bide my time while the fundamentals play catch-up. Meanwhile, caution remains the operative word.

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3 comments to Stocks and risky assets stumble

  • Prieur – don’t know how others judge it but this is an excellent post. That’s probably because my own thinking dovetails with yours exactly and you flesh it out with better information. To your points might I add a couple?
    We’ve been in a sentiment driven market fueled by a Risk On trading mentality based on CB’s liquidity injections (read carry trade?). That’s result in pendulum swinging between almost all assets (stocks, commodities, emerging,…) and US safety.
    Economic fundamentals tells us that the Fed will likely have to leave rates at current levels into late 2010 or even 2011 which means there’ll be plenty of fuel for the trade.
    On the other hand early next year economic realities instead of policy and inventory re-build will be more visible and stimulus will be fading.
    On a longer horizon I expect that de-leveraging will shift trade patterns, lower Chinese export demand and put more support under the $.
    Might want to look at the appropriate timeframes vs. the factors you’ve covered here.

  • Frank W

    Yes, but which way will the fundamentals play catch-up? I note that GAAP earnings have improved greatly, since the last figure of 142 I viewed. Moreover, according to Prieur’s forward earnings estimates, things are not looking bad at all, especially to most market participants who couldn’t care less about GAAP earnings, but prefer to eyeball operating earnings, because they always are fabricated to look better. But the other thing to contemplate is money. The money supply is dropping like a brick. The velocity of money is also dropping like a brick. Since GDP (or Y if you are a fop) = M x V, how can things like company earnings and hence valuations be expected to improve? Still another thing is that the do-anythings couldn’t care less about any kind of earnings or, indeed, the fundamentals in general. In this regard, I note that they have just goosed the DJIA up 200 points in one go. This is near enough to what I expected would happen. I, too, am sitting tight, somewhat confident that my favorite crepe hanger Roubini is right and that things wil eventually go to hell in a handbasket. We can only wait and see, but it may be a long wait with a lot of sideways — or worse — action in the meantime.

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