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 »

US jobs report not so clear cut

May 11, 2009 — Mitul Kotecha

The US jobs report released last week was also not as clear cut as the headline figure suggested. The 539k drop in April payrolls was the smallest decline since October last year. Markets reacted well to the data, with equities continuing to rally as it was taken as yet another sign that the worst is over and compared favourably with the average Q1 monthly payrolls decline of 707k. The US has now lost 5.7 million jobs in a period of 16-months with the bulk of these in the past few months alone.

Nonetheless, the headline drop in payrolls masked the fact that there was a large temporary 72k boost from government hiring due to the upcoming 2010 US census which was a one off boost to hiring before real census hiring begins in the spring next year. Negative revisions to the data subtracted 66k from past payrolls, meaning that past months jobs losses were worse than initially reported. Moreover, the unemployment rate pushed higher, reaching 8.9%, the highest rate since late 1983 and is likely to reach at least 9.5% over coming months if not double digits.

As noted in a previous post “No `green shoots’ in the jobs market”, it will take a long time before the jobs picture turns around. Even the US administration admits that positive employment is unlikely until 2010. Moreover they admitted that growth will have to pick up to around 2.5% before unemployment will fall and this is highly unlikely before some months.

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

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 »

A taxing time in the UK

April 25, 2009 — Mitul Kotecha

It has been a truly gloomy week for the UK economy.    Firstly there was the shock budget announced by UK Chancellor Darling in which the scale of UK borrowing requirements became worryingly clear.  To summarise briefly the government expects tax revenue to come in at around £175 billion or a whopping 12.4% below public spending in this fiscal year.   What’s more the bulk of this is structural or persistent so will not be erased without adding another layer of taxes. 

It will take several years to reduce the budget gap according to the budget estimates, with the government predicting that the deficit as a percent of national income will drop to 1.2% by 2017-18 but this relies on highly ambitious forecasts.  The scale of government borrowing required and the reliance on government bonds to bridge the gap is worrying enough and has caught the attention of ratings agencies.   It also effectively rules out further stimulus should the economy turn even more sour than expected or if anticipated recovery does not take effect.    

The bigger problem is that the deficit reduction plans bank on highly optimistic and probably downright unrealistic growth growth forecasts.    This was demonstrated by data released shortly after the budget announcement revealing that the economy shrank by a much bigger than expected 1.9% in the first quarter of this year,  the worst growth outurn since the third quarter of 1979.    So much for hopes that the worst was over at the end of last year.   Although the government has said that this does not alter their budget forecasts, as they are based on growth for future months, it does reveal that they vastly underestimated the depth of the recession in the UK.  

Even the forecasts for economic growth in the next few years look highly ambitious with the pace of contraction forecast to ease over coming quarters and stabilise by year end.   Further out, if growth does not pick up as forecast there is a real risk that not only will tax rates not be reduced for several years but that the UK taxpayer is destined for even higher taxes for years to come.     

There has much press on the increase in the high rate of income tax from 40% to 50% but the reality is that this will only bring in a small amount of revenue and will do little to close the gap between spending and tax revenues.   It will require a substantial easing in spending for the government’s plans to have any validity.  It appears that the aftermath of the bursting of the debt fueled consumer spending bubble is still being felt and will continue to do so for years to come, much to the expense of the taxpayer.

Posted in Bond markets, Economics, Financial crisis, UK. Tags: , , . 1 Comment »
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