Market View - August 2012

Following confirmation from the Environment Agency that April to June 2012 in the UK had been the wettest since records began, some semblance of summer sunshine began fleetingly to make an appearance in July in between the torrential showers of course!

While the UK summer has generally been a washout, global equity markets in July built upon the positive returns seen in June with the MSCI World index rising another 1.20% and up an impressive 5.75% since the start of 2012, while the JPMorgan Global Bond index also rose 1.04% but is only up 1.44% year to date (although the returns from the JP Morgan Emerging Market Bond index are very impressive, up 4% in July and + 11.75% YTD). It was a rather mixed bag of results from regional equity indices however with positive returns from the FTSE Eurotop 100 (+4.16% while +4.71% YTD), the Hang Seng in Hong Kong (+1.83% while +7.39% YTD), the S&P 500 in the US (+1.26%, while +11.87% YTD), and the FTSE 100 in the UK (+1.15%, while +1.13% YTD), while negative monthly numbers came from the MSCI India (-1.06%, while +11.87% YTD)  the Nikkei 225 in Japan (-3.46%, while +2.84% YTD), and the Shanghai Composite in China (-5.47%, while -4.36% YTD).

Whether global equity markets can continue this impressive rally throughout the summer and beyond remains to be seen, with much depending (as ever) upon Mr Market’s mood swings around the euro zone crisis which over the past two years has resulted in a schizophrenic roller coaster ride for investors as each crisis cause a plunge, which is followed by temporary euphoria as yet another solution is trumpeted by European politicians before reality drives the market back down (and yields on troubled member countries’ bond markets start to rise again)! While valuations on many European stocks suggest excellent long term potential and similarly many UK companies look relatively good value, the same cannot be said of American market valuations generally.

This is important of course since historically global equity bull markets have been powered by Wall Street, and dshort.com has recently updated its analysis of whether the stock market there is cheap or expensive. dshort.com’s findings suggest that on a traditional price earnings ratio using the trailing twelve months (or TTM) earnings, the figure of 14.9 does not appear overly expensive, especially when you consider that the average PE on the US market since the 1870’s using the TTM method has been only 15.

However when you look at the picture using the cyclically adjusted price earnings (CAPE or PE10) ratio as devised originally by the father of value investing Benjamin Graham in association with David Dodd, and championed in more recent times by Professor Robert Shiller (author of best seller Irrational Exuberance), market valuations look stretched. The PE10 ratio offers a more realistic valuation measurement tool as it uses the 10-year average of "real" (inflation-adjusted) earnings as its denominator, and coincidentally this ratio has closely tracked the real (inflation-adjusted) price of the S&P Composite historically.

Currently the US market based upon the price of the S&P 500 at the end of July has a PE10 of 20.9, i.e. it is 27% above it average arithmetic mean of 16.4! Similarly fascinating work on this subject has recently been done by Crestmont Research who reach the same conclusion as Doug Short when looking to try and determine when the next secular bull market might begin in American equities.

Both dshort.com and Crestmont Research conclude that it is the PE cycle that has historically created secular bull and bear market cycles. Just as importantly it is not time that determines the duration of a secular cycle, but rather the inflation cycle which can result in relatively short time frames or exceptionally very long ones that can go on for decades!

This is rather depressing news considering that this secular bear market began in 2000 and has already lasted twelve years, but hardly surprising when you consider that at its peak (March 2000), the PE10 of the last secular bull market reached a record level of almost 45 (the next biggest secular bull namely the roaring twenties was tame in comparison peaking at around 33 in 1929)! Historically new secular bulls on Wall Street have only ever begun once the PE10 has dropped into single figures so unless this time it really is different, the likelihood is that we could be facing several more years and maybe a decade or more before the next secular bull can commence!

Meanwhile the market is likely to go broadly sideways, but of course there will always be attractive opportunities within regional markets and selective asset classes, especially in the emerging economies. At times like these capital preservation will of course remain the primary objective.