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 »

Anxiety over Swine flu

April 29, 2009 — Mitul Kotecha

Although I have been writing about various factors that could derail the rally in equity markets and improvement in risk appetite over recent weeks I did not envisage that a virus such as Swine flu would be one of the factors to consider. However, it is and the stress and anxiety about its effects on the economy and of course health are rising rapidly.

In Hong Kong where I have been based for the last 8 months the concerns are particularly acute. Exposed from a high proportion of tourism as a percent of GDP, high population density and its importance as an air travel hub, Hong Kong is somewhat more sensitive than many other countries. Moreover, the memories of SARS and its devastating impact on the economy still linger for many people. A local paper revealed such tensions in its headline, “its creeping closer”

Nonetheless, there is little in terms of concrete evidence to go on and outside of Mexico the health impact of the virus has not been as severe. Even in Mexico there have been conflicting reports about the actual amount of deaths, with some putting it at a much smaller number. Until there is some clarity markets will continue to react to the uncertainty. The rapid spread of the flu has sparked fears of a global pandemic but it has yet to be categorized as such.

Risk indicators have not yet reacted sharply even if equity markets have been hit over recent days, suggesting that at the least there is not a panic in markets. Even the usual FX beneficiaries of higher risk aversion such as the US dollar and Japanese yen have not strengthened and remain in a broad range. It is difficult to predict the damage from the flu and much depends on its severity and how much it spreads but the relative calm in the market is at least encouraging for now.

Posted in Asia, Currencies, Economics, equity markets. 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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