It is well known that markets have an outstanding record of reverting to their long-term averages despite occasional irrational behavior from time to time. One of the most popular measures of market value is the P/E ratio. The price to earnings ratio of the S&P500 currently stands at 15.3 or 31.6, depending on the use of trailing or forecast earnings. This represents a meager return of between 3.2% and 6.5% compared to a "risk-free" rate of 4.6% for 30-year US. Government bonds.
It therefore seems clear that the bear market is not over and that the best outcome one can hope for is several more years of single-digit returns in US markets. This should not be a major surprise given that US stock markets have taken up to 25 years to regain their dizzying heights in the past. One of the reasons for the disbelief of many investors may be that their generation has not known any period of negative returns over a three-year period. The last such event was during the oil crisis in 1975 with only one momentary negative return in the recession of 1990 as shown in the accompanying chart.
Many investors may not realize that the P/E ratio has increased in many cases since the market top of 2000 because corporate profits have been falling faster than the stock market. This alone is a reliable sign of remaining downside.
With a return of the P/E to its long-term average of 15.6, the S&P500 should fall to between 395 and 816, depending on how accurate or optimistic the earnings forecasts are. Regarding these forecast earnings, it is worthwhile to note that the companies in the S&P500 will have to more than double their current profits within the next 12 months just to be in line with these expectations! Yet, all three sectors of potential consumption are moribund: exports, government, and domestic consumers.
From the global recession, it is clear that there will be no export-led expansion in the near term. Much of the world seems frozen and dependent in anticipation of a hoped-for U.S. recovery. As for government spending, many will remember the much vaunted "peace dividend" from the Soviet Union disintegration in 1989 that helped propel the markets to new heights - more government spending was diverted from defense to productive sectors.
What is to be said now that we have entered a more nebulous, expensive and inefficient war on terrorism? The Bush administration's war strategy will now take money away from productive investments. Add to this the budget reversing from surplus to deficit, decreasing tax revenues, and increasing social support payments; the US government's hands are tied.
Finally, the last hope remains with US consumers who are already winded and at their credit limit. Unemployment is persistently high, confidence flagging, incomes stagnating, debt setting new records, spending as a percentage of disposable income falling, recent retail numbers showing a reversal. The American consumer's exuberance is clearly over.
Without increasing sales, aggregate corporate revenues cannot increase. Many companies will try to survive by cutting their margins, thus their profits, which will translate into lower valuation. Assuredly there will be some, like Dell, to take advantage of this to increase their market share but this will be at the expense of their competitors.
Critics may argue that such valuation models are no longer valid but we now know that the much-vaunted "new economy" and productivity miracle were illusory. The new economy turned out to be simply a more efficient way to transfer vast fortunes from the many to a few individuals - call it the Inverted Robin Hood corporate model. The US is no longer the safe haven it was thought to be and this newly recognized risk of corporate governance in the bastion of capitalism will push stocks lower yet.
Further, much of the "new economy" argument rested on productivity improvements. But we now know that most of this was limited to technology sectors, which are now better known for gargantuan destruction of shareholder value than for any technological breakthrough. Hundreds of billions of US dollars have already been written off by just a handful of corporations and there are many bad surprises waiting in the wings, regardless of executive pledges to the contrary.
To wit, if you read the half-page SEC document that chief executives had to sign, you will quickly realize that the entire exercise was nothing more than a tactic to calm investors. Investors should slowly start to diversify their portfolios more globally, funds flowing more quickly and efficiently to areas of high real growth.
As we pointed out in a recent analysis, the volatility of US markets has been increasing since 1950, even accelerating in the last ten years. As we pointed out in our July 2002 analysis, the Dow Jones Industrial Index is now more volatile than the Hang Seng Index. We know that the riskier an asset, the higher the return is demanded by investors. This suggests that the price of corporate assets should be even lower than the long-term average, leading to a convergence of prices across markets.
In addition, there is a plethora of risks: another terrorist attack; war with Iraq; a new round of protectionism; American isolationism; Muslim movements in allies such as Saudi Arabia leading to another oil crisis; the on-going disintegration of South America right in America's backyard.
To survive and prosper in these markets, all investors have to be prepared to return to their roots and devote significantly more energy to finding the true profit leaders throughout the world instead of relying on momentum investing in their own countries. In this new global investment environment, most opportunities will not be found in the US until the current anomalies have worked themselves out of the market.
In that sense, it is a whole new world out there, with US markets fading from favour in the short-term. This also presents outstanding opportunities for those who recognize this shift and invest in other markets. Asian markets are poised for an extraordinary opportunity if they are properly explained and promoted.
Raymond Blondin is Managing Director of Finasia, a provider of corporate financial data to financial institutions. For more information visit www.finasia.com.hk
