Following a strong start to 2009, equities had a disappointing showing last week, and given everyone’s painful 2008 memories, most investors were probably quick to conclude: “Oh no! here we go again”… But does this reaction make sense? As mentioned in the past, investment returns typically depend on four very important variables:
* Where do we stand on the valuation front? Buying overvalued assets can work in the short term during rising markets, but is hardly a long-term recipe for getting rich. The good news is that today, almost all assets (bar OECD government bonds) are at the very least fairly valued—and many remain very undervalued.
* Where do we stand on the sentiment front? When sentiment is buoyant, company managers are prone to over-reach, take on too much leverage, and jeopardize the long term health of their businesses. At the same time, as the past year has shown, buying assets alongside people who are over-extended can prove highly detrimental… in that forced selling hardly begets rising prices. The good news today is that a lot of the excess leverage has been wrung out of the system—there can hardly be any “weak hands” left. The bad news is that “strong hands” remain hard to identify.
* Where do we stand in the inflation cycle? Changes in prices are a key determinant to asset valuations. In a positive environment, prices remain stable, allowing companies to focus on their core businesses. When prices rise too fast, or decline precipitously, companies worry about their level of inventories, about the ability of their suppliers to continuing delivering, etc… Thus rapidly accelerating inflation, or collapsing prices, typically lead to serious contractions in P/Es (with inflation actually being worse for P/Es than deflation). The bad news today is that we are entering into an overtly deflationary phase, with consumer and producer prices collapsing in almost all major economies. The good news is that this trend may come to a halt sooner than most investors realize as a) central banks are pushing an unprecedented amount of money into the system, and b) the velocity of money, after an 18 month long pull-back, may finally be creeping back into positive territory.
* Where do we stand in the economic cycle? The three measures above combine to form the “P” in the P/E equation. But of course, valuations also depend on the “E”, and earnings are driven first and foremost by the economic cycle. And on this front, the news continues to remain bleak. Whether it be record job losses in the US, contracting retail sales in Germany, or shocking industrial production numbers out of France, there is little on which to hang one’s hat. In fact, the only piece of positive economic news we could rake up is the turnaround in the diffusion index of Asian leading indicators.
So where does all this leave us? On the positive side, most equity markets today are extremely undervalued and “weak hands” and other over-levered investors must have been shaken out by now. This good news is mitigated however by the fact that equity investors, having taken such a beating over the past year, now have little tolerance for pain of any kind. And with the visibility on both prices and economic growth still very limited, and unlikely to get better in the very near term, it is hard to think that equity markets will not remain choppy over the coming quarters. However, if investors do buy into the belief that the combination of an unprecedented monetary loosening, fiscal easing and low oil prices will help the US and Asian economies recover by the second half of 2009, then any significant dip in equity markets over the coming months should be seen as a buying opportunity.
(Courtessy of GaveKal Research)
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