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Saturday 14 November 2009
Believing in the bears, running with the bulls
Given the strength of the stock market rally over the past eight months, and considering just how supportive conditions are for share prices right now, it might seem surprising that anyone at all is still bearish on equities.
Given the strength of the stock market rally over the past eight months, and considering just how supportive conditions are for share prices right now, it might seem surprising that anyone at all is still bearish on equities.
After all, following this year’s cost reductions, company profits are looking healthy, shares look relatively cheap compared with 10-year averages, and interest rates are set to stay low for a long time to come. As strategists at research company GaveKal put it in a recent note: “High profits, low valuations, low cost of capital, what’s not to like?”
Yet despite all these reasons for optimism, market bears abound. One of the grizzliest is Albert Edwards, who yesterday forecast that world equity markets would slump back to fresh lows next year.
The London-based strategist for French bank Societe Generale may have a reputation as a perma-bear, but he has made some smart calls over the years. In the mid-1990s, he was among the few analysts to warn that swelling current account deficits threatened danger for the emerging economies of Southeast Asia.
Then, as the dotcom bubble inflated towards the end of the decade, he warned that investors’ earnings expectations were wildly unrealistic. And two years ago, he advised clients to get out of equities, having warned that United States economic growth was based on “Kilimanjaro-like mountains of debt”.
Now he is arguing that global equities have entered a structural bear market, and that the sell-off still has a long way to go before stock prices finally bottom out.
Like other sceptics, he points to the first chart to back his views. Compiled by Yale University economics professor Robert Shiller, it shows the real cyclically adjusted price-earnings ratio for the S&P 500 Index of US stocks all the way back to 1881.
That’s quite a mouthful. In simpler terms, what Shiller has done is to calculate a price-earnings valuation for the index based on a 10-year moving average of earnings - in order to strip out the effects of the business cycle - and then adjusted that for inflation.
Bears like Edwards love this chart. To them, it demonstrates that equities have been severely overvalued for much of the past 20 years; that last year’s crash was simply the continuation of a structural bear market which began in 2000, and that even at March’s low, the S&P 500 only fell to roughly its long-term average valuation.
Edwards notes that previous bear markets have only ended when the ratio has reached single figures and says that this time will be no different. According to him, the current run-up is simply a temporary rally in an ongoing bear market. He argues that the S&P will not finally bottom out until it falls to about 400 points - another 63 per cent drop from its present level.
If he’s right, it means bad news for holders of Hong Kong stocks. As the second chart shows, the Hang Seng Index has been tightly correlated with the S&P 500 in recent years. If that linkage continues - and the tyranny of global capital flows means it is likely to - then a drop in the S&P 500 to 400 implies a fall in the Hang Seng to around the 9,000 level. That would wipe out almost all the market’s gains since stock prices recovered from their Sars low of 2003.
Happily, the outlook isn’t entirely gloomy. Edwards believes this derating of global stocks will take a long time. He thinks the process will be similar to the long repricing of Japanese stocks relative to bonds, which has now lasted almost 20 years.
Although the long-term trend in stock prices has been downward, during that time, rallies of 25 per cent have been common, frequently coinciding with government stimulus efforts. And occasionally, there have been much bigger rallies of 50 per cent or more.
So even believers in Edward’s ultra-bearish outlook for stock markets should be able to make handsome returns, provided they are ready to jump into the ring when the bulls are running.
1 comment:
Believing in the bears, running with the bulls
Tom Holland
11 November 2009
Given the strength of the stock market rally over the past eight months, and considering just how supportive conditions are for share prices right now, it might seem surprising that anyone at all is still bearish on equities.
After all, following this year’s cost reductions, company profits are looking healthy, shares look relatively cheap compared with 10-year averages, and interest rates are set to stay low for a long time to come. As strategists at research company GaveKal put it in a recent note: “High profits, low valuations, low cost of capital, what’s not to like?”
Yet despite all these reasons for optimism, market bears abound. One of the grizzliest is Albert Edwards, who yesterday forecast that world equity markets would slump back to fresh lows next year.
The London-based strategist for French bank Societe Generale may have a reputation as a perma-bear, but he has made some smart calls over the years. In the mid-1990s, he was among the few analysts to warn that swelling current account deficits threatened danger for the emerging economies of Southeast Asia.
Then, as the dotcom bubble inflated towards the end of the decade, he warned that investors’ earnings expectations were wildly unrealistic. And two years ago, he advised clients to get out of equities, having warned that United States economic growth was based on “Kilimanjaro-like mountains of debt”.
Now he is arguing that global equities have entered a structural bear market, and that the sell-off still has a long way to go before stock prices finally bottom out.
Like other sceptics, he points to the first chart to back his views. Compiled by Yale University economics professor Robert Shiller, it shows the real cyclically adjusted price-earnings ratio for the S&P 500 Index of US stocks all the way back to 1881.
That’s quite a mouthful. In simpler terms, what Shiller has done is to calculate a price-earnings valuation for the index based on a 10-year moving average of earnings - in order to strip out the effects of the business cycle - and then adjusted that for inflation.
Bears like Edwards love this chart. To them, it demonstrates that equities have been severely overvalued for much of the past 20 years; that last year’s crash was simply the continuation of a structural bear market which began in 2000, and that even at March’s low, the S&P 500 only fell to roughly its long-term average valuation.
Edwards notes that previous bear markets have only ended when the ratio has reached single figures and says that this time will be no different. According to him, the current run-up is simply a temporary rally in an ongoing bear market. He argues that the S&P will not finally bottom out until it falls to about 400 points - another 63 per cent drop from its present level.
If he’s right, it means bad news for holders of Hong Kong stocks. As the second chart shows, the Hang Seng Index has been tightly correlated with the S&P 500 in recent years. If that linkage continues - and the tyranny of global capital flows means it is likely to - then a drop in the S&P 500 to 400 implies a fall in the Hang Seng to around the 9,000 level. That would wipe out almost all the market’s gains since stock prices recovered from their Sars low of 2003.
Happily, the outlook isn’t entirely gloomy. Edwards believes this derating of global stocks will take a long time. He thinks the process will be similar to the long repricing of Japanese stocks relative to bonds, which has now lasted almost 20 years.
Although the long-term trend in stock prices has been downward, during that time, rallies of 25 per cent have been common, frequently coinciding with government stimulus efforts. And occasionally, there have been much bigger rallies of 50 per cent or more.
So even believers in Edward’s ultra-bearish outlook for stock markets should be able to make handsome returns, provided they are ready to jump into the ring when the bulls are running.
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