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Saturday, May 18, 2013

Room for appreciation in some bourses

18 May 2013 08:49

Still cheap by historical standards

STOCK markets in many parts of the world are hovering at multi-year highs. Should investors be scared? I looked at five markets this week - Singapore, Hong Kong, South Korea, Japan and the US - to ascertain their prices relative to their value over the past few decades.

In the first set of charts, I plotted the various market indexes against the Graham and Dodd P/E. The latter tries to smooth out the business cycle's impact on earnings by using a 10-year moving average of earnings. In these graphs, I have also included the 10-year moving average earnings per share of the various indexes.

The indexes I can find for Hong Kong and Japan in Thomson Datastream with a long enough history are those which excluded technology, media and telecoms stocks.

From the first set of five charts, you can see the rise in earnings per share for all the markets over time. In Singapore's case, the rate of earnings growth picked up significantly from 2004 onwards. Because of the rise in earnings, the Graham and Dodd P/E for Singapore, Hong Kong and Japan are actually at the lower end of their past 30-year range.

The data for Datastream-calculated Kospi 200 Index is shorter, going back to just 1997. For Kospi, the PE is somewhere in the middle of its past 15 years' range. The S&P 500, meanwhile, is about one-third from the bottom of its 35-year range.

The lower the PE, the cheaper the market is supposed to be.

In the next set of charts, I plotted the price index against the "equity risk premium" or ERP. Here, ERP is calculated as the inverse of the Graham and Dodd P/E (that is, the average past 10 years' earnings divided by the current market price) minus the one-year interbank rate. With ERP, we are trying to calculate the earnings yield from the stock market which is in excess of the one-year interbank rate.

The higher the ERP, supposedly the greater the value in the stock market.

For the Singapore chart, the ERP fluctuates over time, but each subsequent peak is higher than the previous one. This is a function of the declining interbank rates.

Each of the previous peaks had also coincided with a market bottom. The last big peak was in early 2009. But even at today's prices, the ERP for Singapore is still at a fairly elevated level of 6 per cent. The story is similar for Hong Kong.

In general, the ERP should move in the reverse direction as the market price. The higher the market goes, the lower the ERP becomes. For Kospi, in the last six months, the market has been moving up, but so has the ERP! This is because of the declining interest rates in South Korea.

Japan's ERP chart looks the best - it's an almost perfect mirror image of the price index! There was great value in the Japanese market in the middle of last year. The sharp rise in the market in the last six months or so has brought the ERP from 5.7 per cent to 3.7 per cent. The current ERP is still high relative to the period from 1995 till 2009. As for the US market, it is still near the top end of its 27-year range.

One concern is that PEs and ERPs are high because of the unsustainably high profit margins. In the US, corporate profit margins has been climbing and are at record highs now. But not so for the other markets, where profit margins have been relatively stable. In fact, for South Korea, margins seem to be coming down (see chart).

In his most recent quarterly letter, Ben Inker, co-head of asset allocation at GMO, noted that "high profit margins should not persist in a mean-reverting world, and yet profitability in the US has been higher than long-term averages for most of the last 20 years, oddly pretty close to the same length of time that the US market has been trading above replacement cost".

High valuations imply a low cost of equity capital, which should encourage corporations to issue more equity. A high return on capital (as evident from high margins) should encourage corporations to do more investing. These pressures should gradually push the cost of capital up and the return on capital down.

"But in the period since the mid-1990s, stock issuance has been down and corporate investment has fallen as well, in apparent contravention of the basic rules of capitalism," he wrote.

And when investments are down, profits should in general be down, not up. The relationship of high investments leading to high profits was strong from 1929 till 1986, with a correlation of 0.75. The correlation weakened to 0.43 between 1987 and 1999. And then it went negative from 2000 till 2012. During this period, investments fell but profits went up.

Negative savings

The fall in corporate investments have been made up by negative savings by the government and households.

If profits are to stay high while government deficit shrinks, the current account deficit would have to shrink, household savings fall and dividends rise.

"All else (being) equal, falling budget deficits will hurt profitability. But if we do finally get the much-delayed recovery in investment or continued strong buyback activity, it is possible falling deficits could be absorbed without margins falling back towards historical averages.

"Rising investment would, in all likelihood, sow the seed of falling profits in time through increased competition, as would buybacks and dividends through rising savings or a societal response. But as for when, it is impossible to know," wrote Mr Inker. And it is GMO's view that profit margins are unlikely to have shifted permanently higher.

As for the other markets that we looked at, since it doesn't appear that profit margins are exceptionally high relative to the past, perhaps there is still room for more value appreciation.

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