Why Stocks Are Still Undervalued

Jeremy Warner Daily Telegraph January 19, 2010

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By Jeremy Warner Published: 8:35PM GMT 18 Jan 2010

Comments 7 | Comment on this article

Little more than nine months ago, share prices were staring into the abyss. The prevailing mood among fund managers had rarely been more bearish. We stood, it seemed, on the edge of a second Great Depression. Thankfully, this economic nemesis appears to have been avoided, thus far at least. Stock markets around the world have as a consequence staged one of the most remarkable rallies ever. Somewhat worryingly, given how bearish professional investors were when the market was down in the dumps, surveys show the predominant mood now to be overwhelmingly bullish.

Some might reasonably think this as good a sell signal as any, and indeed outside the narrow confines of City and Wall Street punditry, it is hard to find a single bullish voice. In the financial press and among independent economists, the rally is seen as little more than a mirage driven by cheap money.

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Once this stimulus is removed, it is said, a more realistic appraisal of the outlook for the economy, corporate earnings and dividends will prevail. So convinced of the soundness of their judgment are these bearish voices, there is almost visible anger at the market's self evident failure to do as they say.

Many of them were equally bearish when markets were at their March lows, and that makes them angrier still, having missed out on one of the most sensational bull runs ever recorded by stock markets. Are not investors behaving like Pollyanna in chasing valuat

By Jeremy Warner Published: 8:35PM GMT 18 Jan 2010

Comments 7 | Comment on this article

Wall Street's high priest among Pollyannas, Goldman Sachs, put some of its brightest and best on show in London yesterday to make the bull case, and strange to say, it's rather more plausible than you might assume.

But first, let's take a look at what, superficially at least, still seems a compellingly seductive set of negatives. To the bears, the market, and indeed the world economy, is being kept alive only by official policy action which must at some stage be withdrawn. In fact, that process has already begun. In the UK, quantitative easing is scheduled to end next month, and in the US, a similarly unprecedented programme of asset purchases is also drawing to a close.

The cessation of these purchases has the same effect as a quite substantial hike in short-term interest rates, and raises the obvious question of whether private sector demand can support historically record levels of government debt issuance once central bank demand has been removed.

Already yields have risen substantially. Without more credible deficit reduction plans they will undoubtedly be pushed higher still. In the US, the situation is made more worrying still by the fact that for much of the last year the authorities have been underwriting the domestic mortgage and housing market through the Federal Reserve's "Large Scale Asset Purchase" programme.

Once this ends, mortgage rates will rise appreciably, this at a time when the housing market is still falling. Meanwhile unemployment and negative equity continues to rise. The Obama fiscal stimulus reaches its maximum impact towards the middle of the year, and then tapers off. Where's the demand in the US economy going to come from?

This was no ordinary recession, where an inflationary boom is eventually brought to a halt by the monetary tightening of central banks. Demand tends quite quickly to spring back to life after such recessions, for once inflation has been choked off, interest rates can start falling again, raising disposable incomes and corporate earnings.

What makes this recession different is that it was caused not by inflation but by a credit bubble, which is still very much in its corrective phase. Policy action has not yet succeeded in stemming the resulting asset price deflation – real estate in the US is still falling – or the collapse in private demand for credit.

All of which explains why Goldman Sachs for one expects the US Fed funds rate to remain on hold at effectively zero for at least the next two years.

But hold on a moment. Doesn't this imply a rather more bearish view of the US economy than the consensus, which predicts that US rates will be on the rise again by the third quarter of this year? How's this compatible with a bullish view for equities?

There are three main explanations. The most obvious is that what's happening to the US and Europe is not the whole world. Add continued stellar growth in emerging markets to the subdued growth outlook of the advanced economies and you end up with pretty decent levels of gain in world output – 4.4pc this year and 4.5pc next – according to forecasts by Goldman Sachs. Forget regional variations, globally the economic outlook doesn't look that bad. With the FTSE 100, or even the S&P 500 in the US, a substantial proportion of profits are international.

Second, is not the strength of the rally a case of investors getting hopelessly ahead of themselves? Not necessarily. Its speed and trajectory certainly places it in the same category as the great bear market rallies of 1930s America and 1990s Japan, but there is no rule which says it must end in a similarly brutal manner. In fact, nearly all bear markets eventually culminate in a very substantial rally, the size and speed of which is broadly proportionate to the scale of the preceding crash.

During this "hope" stage of a new bull market, valuations are bound to seem stretched to breaking point. Earnings and growth will typically be contracting even as stock prices are rising. But eventually profits and dividends will play catch-up.

Finally, the scale of this catch-up is more likely pleasantly to surprise than disappoint. In fact, neither earnings nor dividends fell nearly as far as feared in the depths of the bust, which partly explains the strength of the subsequent rally, but that didn't stop companies preparing for the worst by slashing inventories, investment and costs.

Even in the absence of a return to top line growth and pricing power, this downsizing is going to lead to a substantial increase in margins. Strong cash flows mean higher dividends, which can be expected to form a substantial part of overall returns in the years ahead.

In outline, this is the bull case, if for reasons of space a slightly oversimplified version of it. Stock markets never proceed in a straight line and some sort of a setback after such a spectacular recovery is only to be expected. It wouldn't require much of a shock to provoke one. But the foundations for a more prolonged bull phase are certainly there.

Comments: 7

I have no idea whether the hedge funds and bankers can coordinate rises or falls on the stock market. But, unless they can, I doubt whether anyone knows direction. PEs are high, there has seldom been so much uncertainty. Why are the bankers not putting their bonuses in shares rather than property?

I'm sorry, Martin, but John Authers hasn't a clue. Not a clue.

you have obvioulsy taken over from bootle as theis papers worst commentator at the last glance the stocks markets in the US were trading at PE ratios way above 30 even if you belive their trumped up earnings of banks etc at most market bottoms PE ratios are way less than 10 we have yet to achieve that hence this is the most overvalued market in history suckers rally and then we will break the march lows that is almost a given assuming the vampire squid acnnot manipulate it further

Lot of pros missed out on the rally post March. They now hope for a fall to make their figures look better annualised. Pathetic.

I suggest that everyone watch this very interesting 2 minute video about what John Authers of the FT says about an imminant correction. http://www.ft.com/cms/bfba2c48-5588-11dc-b971-0000779fd2ac.html?_i_referralObject=13423932&_i_referrer=rss Personally I beleive that there will be a pull back in the near future, but after that there will be a nice hard rally with more volume (strength).

To their great credit the Goldman Sachs gurus have been optimistic in the face of a wall of pessimism (not the least of which has come from the Telegraph)for some months now. As long ago as September they were advising clients to buy sterling assets on the basis that the pessimism about the UK and the deficits were wildly overstated. Sterling they said was substantially oversold. It fell to the UK commentators and institutions to short sell the UK and they have been wrong. If Jeremy Warner and Edmund Conway are joining the optimists about the UK, we must be in for a major boom!

Fine, OK. But wrong, I'm afraid. The system is still debt-pumped to breaking point. The asset prices have not nearly fallen enough. Write offs will lead to unemployment, reduced purchasing power, reduced profit, reduced share prices.