How compelling are equity valuations?

May 12, 2009 — Mitul Kotecha

Relief over the results of the US bank stress tests, better than expected US jobs data, generally less negative economic data in general, as well as better than expected Q1 earnings provided markets with plenty of fuel over recent days and weeks. This has helped to spur an improvement in risk appetite and a resultant strengthening in equity markets. Meanwhile, government bonds have sold off, commodity prices have risen and the USD has weakened.

At the time of writing the S&P 500 has recouped all its losses for the year, having climbed around 34% from its low on 9th March. To many this has sent a bullish signal about the path of the economy ahead given the historical lag of around 5 to 6-months between equity gains and economic recovery but to others include myself this is sending a false signal. Even if the economy stabilizes any recovery is likely to be slow.

As stocks have risen, cautiousness about the current rally has intensified, with many now calling for equities to correct lower. This could partly reflect sour grapes from those investors who have missed the move in equities (I like to think that I am not in this camp even if I did miss the move) but there is also an element of truth in terms of equity market valuations, which have risen sharply over recent weeks. Although arguing whether stocks are cheap or expensive depends on what measures are used there is even some caution coming from equity bulls.

Bloomberg estimates one measure of equity valuation, the Price / Earnings ratio of the S&P 500 at 14.78, which is still below the estimated P/E ratio of 15.96 but much higher than the P/E ratio of around 10 at the beginning of March. Other estimates also suggest that the current P/E ratio on the S&P 500 is approaching a long run average, which suggests that further upside for equities may be more difficult in the weeks ahead.

What now? So far markets have reacted to the fact that economic conditions are the past the worst and the reaction has reflected less negative economic data releases, with many data releases coming in ahead of expectations. Going forward, it will require actual positive news as opposed to less negative news to keep the momentum going. If positive news is lacking the improvement in risk appetite and equity market rally will falter, especially as valuations are arguably far less compelling now.

I would be interested in your view about whether you think the rally will continue. Please tick the the relevant circle in poll on the sidebar to give your view and also view what others are thinking.

Posted in bank rescue, Bond markets, Commodities, Currencies, Economics, equity markets, Financial crisis, US, US administration. Tags: , , , , , , , , , , , , . 5 Comments »

Stress testing European and UK banks

May 8, 2009 — Mitul Kotecha

The US bank stress tests are finally over and markets are breathing a massive sign of relief. 10 out of the 19 banks tested will have to raise $74.6bn in equity but none of the 19 banks will become insolvent, with additional capital requirements deemed as “manageable”.

It hardly seemed worth getting all stressed up over the stress tests but the results are likely to prompt much debate about the methodology used and will not put to bed the issue of the health of the US financial sector and potential for even more capital raising in the future. This should be the theme of another post but for now I want to discuss what this means for European and UK banks.

The stress tests raise questions about whether the European and UK banking sector should follow the US.  The US administration has used the ratio of tangible common equity to total assets for its stress tests on US banks. This measure has been labeled as old fashioned but one that investors currently prefer. This is also the measure the IMF has used in its recent calculations to work our additional capital requirements for banks globally.

The IMF financial stability report estimated additional credit related writedowns in 2009 and 2010 at $550bn in the US, $750bn in the eurozone, and $200bn in the UK. The IMF estimates that the ratio of tangible common equity to total assets was 3.7% in the US at end 2008 but only 2.5% in the eurozone and 2.1% in the UK. It concludes that the extra capital needed to increase this ratio to 6% would be $500bn in the US, $725bn in the eurozone and $250 billion in the UK.

So will be there similar stress tests in Europe and the UK? The increased transparency that the stress test results have brought about in the US is good news for investors even if no bank was ever going to fail them but they raise a potentially worrying comparison with European and UK  banks which appear to have been far less forthcoming. The figures have been disputed by eurozone and UK officials but assuming the IMF is right the estimates raise some disturbing questions about financial sector health outside the US.

Posted in bank rescue, Economics, Europe, Financial crisis, US, US administration. Tags: , , , , , , . 5 Comments »

Show me the money

May 3, 2009 — Mitul Kotecha

The long awaited results of the US administration’s stress tests for US bank will be announced on May 7th. There have been various rumours and speculation about the details in terms of the extent that banks will require further capital injections and indeed which banks will need such injections. Ahead of the announcement I thought it would be an interesting exercise to look at the potential equity needed in the global financial sector.

Some light on this was shed by the IMF’s recent release of the Global Financial Stability Report in which the fund increased its total estimates of global writedowns to over $4 trillion. The most recent estimates of financial sector writdowns suggest that institutions are only about one-third of the way there.

In other words there is still a considerable amount of writedowns on toxic debt left to be undertaken. The IMF estimated further writedowns in the US in 2009 and 2010 at $550 billion, $750 billion in the eurozone and $200 billion in the UK.

Moreover, they estimate that financial institutions will require $500 billion of additional capital in the US, $725 billion in the eurozone and $250 billion in the UK just to raise the ratio of common equity to total assets (a measure of leverage) to 6%. Even these estimates may prove conservative. After all, the IMF has raised its estimates of total writedowns several times already and will likely do so again. These figures do not even include the need for other financing which when added amounts to around 60% of Bank’s total assets.

The bottom line is that even with all the money that is being provided to financial institutions at present it will be highly unlikely that they will be able to raise sufficient capital if the IMF’s estimates are anything to go by. Consequently balance sheets will contract sharply and deleveraging will continue.  Governments will be forced to provide support for a long time to come and the end result will be either outright nationalisation or alternatively bankruptcy for some institutions that are deemed not too big to fail.  Worryingly the risks are skewed on the downside, especially if the economic recovery is a weak one which I believe is highly likely to be the case.

Posted in bank rescue, Economics, equity markets, Europe, Financial crisis, UK, US, US administration. Tags: , , , , , , . Leave a Comment »

Nervousness sets in

April 20, 2009 — Mitul Kotecha

Over recent days a number of banks including Citigroup, JP Morgan Chase, Goldman Sachs, and Wells Fargo and most recently BoA have revealed a return to profitability in Q1.   In Citigroup’s case it has been reported that earnings were helped by an accounting change that allowed it to post a one off gain of $2.5 billion.   However, it’s stock price was unlikely to have been helped by the announcement of a delay to the planned sale of a stake of 36% to the US authorities until the results of the bank stress tests are known. 

There is no doubt that US banks are being helped by strengthening mortgage demand due to low interest rates, improved liquidity in markets and the huge amounts of money that the government is pumping into banks.   High volatility has also helped boost trading revenues.   Nonetheless, uncertainty about the outlook in the months ahead continues to grow due to the risks from corporate loan defaults, a slide in the commercial real estate market and rising consumer loan delinquencies. 

This suggests it will be difficult for markets to get too bullish even if banks continue to report decent Q1 earnings.   Perhaps demonstrating this, even Citigroup’s better than expected earnings failed to prevent its shares falling on the day of its earnings announcement.   This was followed by a fall in BoA’s shares today in pre-market trading despite revealing that profits tripled in Q1.

Indeed, there are appears to be a degree of nervousness creeping back into markets, indicating that the improvement in risk appetite over recent weeks could be stalling as uncertainty about what lies ahead intensifies.  BoA’s increase in provisions for credit losses in Q1 highlights where this nervousness is coming from.   The results of US bank stress tests is the next hurdle for markets and if anything this could lead to more market tensions, especially if some of the banks are found to be requiring additional capital which looks increasingly likely to be the case.

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10 questions to ask…

April 14, 2009 — Mitul Kotecha

…before you return to the stockmarket.

Equity markets have undergone their biggest 5-week rally since the great depression but there are several questions that should be considered to determine whether the gains will last.

1) Why is the rally in equities broad based? On the face of it a broad based rally should come as good news but it also appears indiscriminate with investors rushing to buy any stocks regardless of the underlying factors. This suggests investors are jumping in without looking where they will land.

2) Why are financial stocks rebounding so strongly? Surely all the problems have not been resolved so quickly. Even if the removal of toxic assets are starting to gain traction markets are unlikely to have anticipated the likely problems coming from a new wave of credit card defaults, and comsumer and corporate loan delinquencies as economic conditions deteriorate and unemployment rises.

3) Have markets factored in the outcome of the results of the stress tests on US banks? These results will be known in about three weeks. Although no bank can fail the tests from a technical perspective, there is every chance that some will be found to be in bad shape and in need of more capital.

4) What effect will the impact of accounting changes have? The relaxation of industry accounting standards in the US mean that it will be difficult to gauge losses on a variety of debt. This could add to the uncertainty surrounding valuations rather than help to end it.

5) How will tensions between banks and the administration impact stocks? There appears to be growing tensions between the US administration and banks over repayment of bailout money and the speed at which banks are removing toxic assets from balance sheets. Many banks in the US are reluctant to announce further writedowns despite pressure to do so.

6) How long will positive data surprises continue? Clearly expectations for economic data had become overly bearish over recent months. Data releases have actually come in better than forecast recently as reality has not been as bad as expectations. This in turn, has helped give more fuel to the market rally. Once expectations become more realistic markets will find little support from positive data surprises.

7) Are markets full pricing in the depth and breadth of the recession? It appears that markets are looking at the current economic downturn as if it was the same as past cyclical downturns. This is unlikely to prove correct as economic conditions will not improve anywhere near as quickly as experienced in recent recessions. Moreover, the jobs market is likely to continue to worsen for many months to come. At best, economic recovery is unlikely until early 2010 and even this may be optimistic whilst any recovery is likely to be slow and mild relative to past recoveries.

8)How compelling are valuations? Although the price side of the P/E ratio has dropped sharply the earnings outlook continues to be negative. Analysts have forecast Q1 earnings to drop by around 37% but as the economy worsens and unemployment rises the earnings outlook could like quite bad for some time to come.

9) Are stocks rallying too quickly? Historically equity markets do not rally so rapidly following such a shock on the downside. Any rally is usually slower.

10) Are stocks rallying too early? Stocks rally around 5-6 months ahead of an upturn in economic conditions but as noted above any recovery in the economy is unlikely before early next year, which suggests the stock rally is premature.

Posted in bank rescue, Economics, equity markets, Financial crisis, US, US administration. Tags: , , , , , . 1 Comment »
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