Published October 21, 2009

Are equities still cheap?

By R SIVANITHY

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IT IS shades of 2007 all over again. In the US, Wall Street is paying out obscenely large bonuses. And globally, stock prices are up more than 50 per cent in seven months and yet everyone is expecting them to keep rising because interest rates are zero. There is belief also that US officialdom will bail the market out if there's trouble, so there's no need to be too concerned.

Meanwhile, in this part of the world, China is being touted as the next best thing to sliced bread and target prices of stocks from all sectors are being constantly raised.

These same conditions were present at the start of 2007, before the US sub-prime and banking collapse, so it looks very much like history is quickly repeating itself. Thanks to those bubble-blowers of last resort, namely the US Federal Reserve and Treasury, risk-taking is back around the world - and back with a bang.

The problem is that if you believe in valuations and fundamentals, stocks are not cheap anymore. Of course, faith in fundamentals presupposes faith in the efficient market hypothesis that current prices properly reflect all available information about future prospects and a level playing field exists for all investors - a deeply flawed hypothesis as 2008's collapse painfully demonstrated.

But assuming that over time investors actually do look at such data as earnings and yields, and assuming all investors have equal access to information, the message from here onwards, when one takes a hard look at simple valuation parameters, has to be that the days of easy gains must slowly but surely be drawing to an end.

Last week, the crossing of the 10,000 mark by the Dow Jones Industrial Average and the regaining of the 2,700 level by the Straits Times Index were applauded by observers as heralding more upside to come.

To be honest, brokers and investment bankers, especially those in the US, cannot realistically be expected to do otherwise since their bloated bonuses depend on a continued ability to spin a bullish yarn.

The reality, however, is that the valuation figures supporting the major indices should at least give one some pause for thought, if not discomfort.

According to Bloomberg's financial service, the S&P 500 sells for a current price/earnings ratio of 20.5 and a forecast ratio of 18. Both figures are high by historic standards and are arguably not justified in an economy with limited growth prospects and largely propped up by trillions of taxpayer money masquerading as 'government stimulus'.

The numbers are also not supported by a paltry dividend yield of 2.3 per cent, while the recent huge quarterly losses announced by major banks like Bank of America and Citigroup should serve as useful reminders that optimistic earnings forecasts by analysts are dubious at best.

As economist Paul Krugman pointed out this week ('When will banks start lending again?' BT Oct 20), the earlier profits these banks reported were thanks to creative accounting, but the latest numbers are more indicative of a bleeding real economy faced with persistent unemployment and continuing losses on mortgage loans and credit cards.

(He also wrote that there's an urgent need for financial reform to be passed because banks will surely be taking on more risk, and 'when bankers gamble with other people's money, it's heads they win, tails the rest of us lose' - again, shades of 2007 all over again).

Elsewhere around this region, valuations are also not cheap anymore. The Straits Times Index's current PE is 21 while the forecast figure is 18 - almost exactly the same as the S&P 500's - compared to historic norms in the mid-teens, while the Hang Seng's comparable figures for the present and future are 24 and 18 respectively.

The inverse of the expected PE gives all these indices as trading at an earnings yield of 5.6 per cent, which still compares favourably with returns available from fixed deposits, but investors may wish to note that in Australia, the 10-year government bond yield is also around 5.6 per cent. The 10-year US Treasury bond, in the meantime, now yields 3.4 per cent.

This doesn't mean that stocks cannot go higher - after all, the last bubble lasted from 2003 when the Sars epidemic and the invasion of Iraq passed, to mid-2007 when the US banks started toppling like tenpins.

But in order for more upside to materialise, earnings estimates will have to be raised and companies will have to deliver pretty spectacular growth in the quarters ahead to meet those estimates.

With risk appetite growing as rapidly as it has over the past seven months, there's little doubt that the financial community will respond in positive fashion by finding novel ways to keep the bandwagon rolling (and with it, their bonuses). For example, one ploy for calling a buy on a company with no earnings is to resort to raising book value; another is to project earnings several years into the future, beyond what is currently visible if the present is littered with losses; while yet another is to point to higher prices commanded by supposedly similar companies in other markets as justification.

Smart investors would do well to keep an eye on valuations and to note that they are looking stretched all over the world.