Hope for equities despite war and high US valuations
22 October 2001
On 15 October 2001, The Business Times published an article "Market see hope amid the gloom". The article mentioned several factors accounting for the stock markets' recent rebounds from the lows hit after the World Trade Center attack. These include ample liquidity (US$1 trillion sitting in US money market accounts as well as a slew of monetary easings led by more Federal Reserve rate cuts) impending fiscal stimulus (some US$165 billion which the US government is poised to pump into its economy) and signs of a bottom to the recession (better-than-expected corporate earnings, extremely low inventory levels and indications that orders could pick up within 6 months).
However, some analysts recommended caution. Lim Say Boon, director of OCBC Investment Research, believes that the worst case scenarios for the war in Afghanistan have not been fully discounted. While acknowledging that many recent wars have not proven particularly harmful to stock markets, particularly the Korean War and the Gulf War, he pointed out that the current war against the Afghan-based terrorists is different: "The Korean war and the Gulf War had clear enemies with 'addresses'. This one does not."
Personally, I think that the difference between the war in Afghanistan and the other two wars mentioned may not be as significant to the stock market as Lim makes it out to be. While it is true that this war may turn out to be more protracted than the Korean and Gulf wars, it is less serious in other respects. The Korean War involved North Korea, a communist country right at the doorstep of both the Soviet Union and China, the former already a nuclear power. The Gulf War was fought in the oil-rich Middle East and could have seriously disrupted critical oil supplies to the rest of the world. If stock markets could shrug off such concerns, there should be no reason why they cannot do the same with the war in Afghanistan.
The other bear mentioned in the article was Kevin Scully, managing director of Netresearch Asia. "The markets do not seem to have fully discounted the poor earnings visibility," said Scully. "In 1990, when the US was in its last slowdown, the Dow was trading at a price-earnings multiple of 15 times. Today it's 23 times. At 15 times PER, this would translate into 6,000 points on the Dow. Do you think our market can sustain these levels if the Dow plummets to 6,000? I think not."
In my previous article on 12 October, I suggested that a stock market rebound need not occur only when the economy shows signs of an impending recovery. Market valuation and liquidity are also important factors. Scully's comments suggest that valuation is not favourable given the current economic conditions, leaving a market rebound dependent on only one factor -- liquidity.
Edward Yardeni, chief investment strategist for Deutsche Banc Alex. Brown, has a simple formula that ties the economy, valuation and liquidity together. Apparently used by the Federal Reserve as well, this formula gives the fair value of the S&P 500 Index as the 12-month forward consensus earnings per share divided by the 10-year treasury bond yield. Using an estimated 12-month forward earnings per share of $53.5 and the treasury bond yield of 4.62 percent on 19 October, the fair value for the S&P 500 is 1158. This compares with an S&P 500 close of 1073.48 on 19 October, indicating that the US market is undervalued by about 7.3 percent.
Being the simplified formula that it is, the result should not be taken at face value. But it does illustrate the hazard of comparing only the current P/E ratio with the P/E ratio in 1990 without taking into consideration the much-higher treasury bond yield of well over 8 percent prevailing in the earlier period.
If there is some doubt about whether the US market is overvalued or undervalued, there should be none about the Singapore market. The Straits Times Index is currently trading at a forward P/E ratio of about 14. At an absolute level, that is pretty low. At the bottom of the 1998 bear market, the STI was trading at a forward P/E ratio of about 17. 10-year treasury bond yields in Singapore then were about 5 percent. Now it is 3.28 percent. Using Yardeni's formula, that implies a fair P/E of about 30.5. In other words, the STI is worth over twice as much as it is now trading.
However, Scully also warned that if the US market falls, the Singapore market is likely to get dragged down as well. Indeed, if the US market plunges further from current levels, then I certainly agree with this view. But as it is not clear that the US market is as overvalued as Scully suggests, further falls -- if they do occur -- are likely to be limited, either in extent or in duration.
And it may be worth noting that over longer time intervals, the correlation between the US and Singapore stock markets is not that high. In fact, during the 1990s, the correlation between semi-annual changes in the S&P 500 with semi-annual changes in the STI was practically zero. From 1995 to 2000, the correlation was actually negative at -0.04, although not significantly so. In each of the four years from 1995 to 1998, the US market gained at least 20 percent. In contrast, the Singapore market gained 1 percent in 1995, then fell in every year from 1996 to 1998.
What happened in the 1990s was that in 1993, there was a massive flow of investment funds into emerging stock markets, especially in East Asia, fed by stories of the Asian economic miracle. That created a raging bull run in East Asian stock markets that year. However, that bull run was stopped by interest rate hikes by the Federal Reserve in 1994. When the next stock market euphoria started in 1995, investors had shifted focus from the miracle economy to the new economy and investment funds went not to East Asia but to the US. Indeed, East Asian markets were not only neglected but hammered by the financial crisis of 1997-98.
By now, not too many investors will have too many illusions about the promises of the Asian economic miracle or the new economy. Instead, new investment themes will undoubtedly appear. Economic growth rates among countries may diverge. And, of course, current valuations vary widely across markets. All these can result in widely divergent performances in stock markets over the next few months. While the on-going worldwide recession will be a drag on all stock markets, investors would do well to also assess each market on its own merit.
Disclaimer: The commentaries posted here represent the opinions of the author at the time of posting and should not be taken as investment advice. Readers who wish to take any investment action based on information obtained from this site should seek appropriate advice from a qualified financial adviser.