What's the economy got to do with stocks?
26 October 2001
The struggle between the bulls and the bears continue, not only in the stock market itself but in the media as well. Various analysts have been writing or quoted in the media as expressing bullish or bearish views. Most of the bulls' case rests on the fiscal and monetary stimuli being provided by governments around the world, while the bears have emphasised the weakness of the world economy and the lack of visibility of corporate earnings.
However, as I have argued in my article on 12 October, and again on 22 October, the picture is not complete without considering valuation. Many of the great bull markets of the past have occurred despite weak economic conditions and corporate earnings. Loose monetary conditions have provided much of the impetus for bull markets, but also important are depressed stock prices, which provide attractive valuations for long-term investors to buy stocks despite poor near-term outlooks.
In today's The Business Times, there were two articles which presented views that I think more analysts should take note of. Both happen to be bearish views, but that is not really the main point here.
In the article "Wall St rally reels them in, but is it the real thing?" the writer quoted Richard Russell, author of the long-established Dow Theory Letters, as writing recently: "Some of the smartest people in the investment business believe the worst is over. Merrill Lynch launched a big ad campaign today (was it five pages in The Wall Street Journal?) proclaiming they were 'bullish on America.'
"I'm bullish on America too, but what's that got to do with stocks? You could have been bullish on America at the peak of every bull market in history, and you would have lost your shirt a year later."
The comment Russell made -- that markets can go down even when the economy is going up -- is exactly the reverse of what I have been suggesting in my recent articles -- that markets can go up even when the economy is going down. But the basic point is the same: The near-term prospect for the economy alone cannot foretell the near-term direction of the stock market.
In the other article in The Business Times, "Bull market emerging or dead-cat bounce?" the writer, normally already bearish on economic grounds, quoted a comment featured in the 8 October edition of US financial newspaper Barron's. The comment, made by independent market strategist Steve Puetz, "criticised the bullish view and said that going by book values, the Dow Jones Industrial Average is grossly overvalued".
"There is quite a difference between stocks being down from their highs and stocks being bargains," he said. "By looking at how accountants estimate the value of the Dow, there has been no gain in the net worth of the Dow stocks in the past 12 years.
"The peak occurred in 1998. Since then, a combination of insufficient profits, too many one-time charges and excessive dividend payouts have combined to erode away the Dow's highly leveraged balance sheets."
Puetz said stocks will eventually have to revert to their historical average of 1.5 times book value. According to Puetz, the Dow currently trades at around nine times book value. Thus, he concludes that "the Dow has a long way to fall and this bear market won't be over until the popular average collapses to the 1,000-1,600 area". The Dow closed on Thursday at 9462.90.
I don't necessarily agree with everything Puetz said. For example, Puetz suggested that excessive dividend payouts since 1998 contributed to the erosion of balance sheets. In reality, average dividend payout ratios in the US market have been dropping from around 40-50 percent in the early 1990s to below 30 percent in recent years. The accumulation of debt to finance stock buybacks has probably done more to hurt balance sheets.
Also, he estimates that the Dow is trading at around nine times book value. In contrast, by conventional accounting, the Dow is trading at about four times book value. To get another feel of this measure of value, consider the calculations of Andrew Smithers and Stephen Wright, authors of the book Valuing Wall Street. On their website www.valuingwallstreet.com, they estimate that for the US stock market, the q ratio, defined as the market value of companies' equity to the replacement cost of their assets minus the market value of liabilities -- or analogous to the price-to-book ratio -- is about 1.2, or about 1.6 times the average historical value. So there may be some exaggeration in Puetz's figures.
Nevertheless, Puetz's points on the poor state of the US corporate balance sheet and high price to book ratios are essentially valid.
In my 22 October article, I had pointed out that the US stock market can be considered overvalued or undervalued depending on how one compares the current price-to-earnings or P/E ratio to historical values. But for the Singapore market, the P/E ratio looks unambiguously low compared to historical values.
The same holds true for the price-to-book ratio. According to DBS Vickers Securities, the Singapore market is currently trading at a price-to-book ratio of about 1.2. This is much lower than the historical ratio of over 1.8. It is even lower than the US market average of 1.5 mentioned by Puetz.
So once again, we have to conclude that the Singapore market looks cheap. So is it likely to build on its recent gains? Probably not. The Singapore economy appears to be in an unusually deep and long recession. Recovery appears quite a way off. The market is likely to consolidate over the next few months, possibly even re-testing its low.
Just don't be too surprised if the market decides to ignore the economic gloom and takes off on its own.
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.