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Monday, 3 November 2008
Pray that markets are unduly pessimistic
There are two opposing ways of thinking about what is going on at the moment in financial markets. The first is that after all the deleveraging, panic-selling and forced liquidation of the last month, financial markets have overshot wildly.
There are two opposing ways of thinking about what is going on at the moment in financial markets. The first is that after all the deleveraging, panic-selling and forced liquidation of the last month, financial markets have overshot wildly.
As a result, with stocks trading at close to the book value of their assets, price-to-earnings ratios in single figures for the first time in years and dividend yields near historic highs, equity markets are priced for economic annihilation.
According to this view, markets are offering the buying opportunity of a lifetime, and investors should fill their boots with cheap assets.
The opposite approach is to assume that financial markets are more or less accurate indicators of what is going to happen in the real world, and then to look at current valuations to see what they imply about the trajectory of economies in the near future.
Tim Bond, head of global asset allocation at Barclays Capital in London, has had a crack at the second approach, and his projections make uncomfortable reading.
Although falling interbank interest rates and subsiding prices for insurance against bank defaults reflect growing confidence that the threat of a systemic collapse of the world’s financial system has been contained, other measures give less cause for cheer.
Consider the difference between the yield on US investment-grade corporate bonds and the yield on government debt, which is trading at its widest spread since the Depression of the 1930s (see the first chart).
According to Mr Bond’s models, this means the debt market is pricing in a 15 per cent year-on-year rate of contraction in the United States’ gross domestic product and a decline in the corporate profits-to-GDP ratio to zero.
That sounds extreme, but it is not impossible. US GDP contracted 16 per cent in 1931 and even more in 1932, and Mr Bond argues that it is “entirely plausible” that US corporate profits shrank to nothing at the time.
Similarly, while a price-to-earnings ratio for the US stock market of 11 times estimated earnings for next year might sound enticingly cheap, it is not unusual by historical standards.
In fact, long-term data series show that price-to-earnings ratios have been at or below 11 times for almost a quarter of the time since 1871. And, as the second chart shows, if we assume stock market valuations have something to tell us about the real world, then price-to-earnings ratios could actually be indicating a US downturn even more severe than during the Depression.
It is not only US markets that are sending out such dire warnings. The market in equity index dividend swaps is pricing in an almost 50 per cent cut in both Europe-wide and British corporate stock dividends over the next two years.
Again that sounds extreme, but it is not unprecedented. Although British stock dividends only fell about 33 per cent during the Depression, they dropped 49 per cent between 1917 and 1919, at the end of the First World War.
Markets are not only priced for severe recession, a collapse in corporate profits and deep dividend cuts. Ominously, the interest rate swap market is also pricing in three years of deflation for the US, along with a return to falling prices in Japan.
Worryingly, data from the US on Friday appears consistent with a possible episode of deflation. Although personal incomes rose over the year to September, household spending still fell as ordinary Americans reacted to the drop in asset prices by raising their savings rate.
In other words, US consumer demand is deteriorating, despite successive interest rate cuts, which could well indicate that a period of deflation is on the way.
Alternatively, of course, the first view could be right: that markets have got it wrong and are being unreasonably pessimistic.
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Pray that markets are unduly pessimistic
Tom Holland
3 November 2008
There are two opposing ways of thinking about what is going on at the moment in financial markets. The first is that after all the deleveraging, panic-selling and forced liquidation of the last month, financial markets have overshot wildly.
As a result, with stocks trading at close to the book value of their assets, price-to-earnings ratios in single figures for the first time in years and dividend yields near historic highs, equity markets are priced for economic annihilation.
According to this view, markets are offering the buying opportunity of a lifetime, and investors should fill their boots with cheap assets.
The opposite approach is to assume that financial markets are more or less accurate indicators of what is going to happen in the real world, and then to look at current valuations to see what they imply about the trajectory of economies in the near future.
Tim Bond, head of global asset allocation at Barclays Capital in London, has had a crack at the second approach, and his projections make uncomfortable reading.
Although falling interbank interest rates and subsiding prices for insurance against bank defaults reflect growing confidence that the threat of a systemic collapse of the world’s financial system has been contained, other measures give less cause for cheer.
Consider the difference between the yield on US investment-grade corporate bonds and the yield on government debt, which is trading at its widest spread since the Depression of the 1930s (see the first chart).
According to Mr Bond’s models, this means the debt market is pricing in a 15 per cent year-on-year rate of contraction in the United States’ gross domestic product and a decline in the corporate profits-to-GDP ratio to zero.
That sounds extreme, but it is not impossible. US GDP contracted 16 per cent in 1931 and even more in 1932, and Mr Bond argues that it is “entirely plausible” that US corporate profits shrank to nothing at the time.
Similarly, while a price-to-earnings ratio for the US stock market of 11 times estimated earnings for next year might sound enticingly cheap, it is not unusual by historical standards.
In fact, long-term data series show that price-to-earnings ratios have been at or below 11 times for almost a quarter of the time since 1871. And, as the second chart shows, if we assume stock market valuations have something to tell us about the real world, then price-to-earnings ratios could actually be indicating a US downturn even more severe than during the Depression.
It is not only US markets that are sending out such dire warnings. The market in equity index dividend swaps is pricing in an almost 50 per cent cut in both Europe-wide and British corporate stock dividends over the next two years.
Again that sounds extreme, but it is not unprecedented. Although British stock dividends only fell about 33 per cent during the Depression, they dropped 49 per cent between 1917 and 1919, at the end of the First World War.
Markets are not only priced for severe recession, a collapse in corporate profits and deep dividend cuts. Ominously, the interest rate swap market is also pricing in three years of deflation for the US, along with a return to falling prices in Japan.
Worryingly, data from the US on Friday appears consistent with a possible episode of deflation. Although personal incomes rose over the year to September, household spending still fell as ordinary Americans reacted to the drop in asset prices by raising their savings rate.
In other words, US consumer demand is deteriorating, despite successive interest rate cuts, which could well indicate that a period of deflation is on the way.
Alternatively, of course, the first view could be right: that markets have got it wrong and are being unreasonably pessimistic.
Let’s hope so.
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