Three reasons to be wary of stocks
By
Deputy Editor
Tim Bennett Feb 20, 2009
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Are we about to enter a golden decade for equities? The Daily Telegraph's Tom Stevenson reckons we may be. "The nine-year unwinding of excessive valuations has now gone on for so long and cut so deep that even a new world of heightened volatility... is well and truly in the price for a long-term investor." He cites the Barclays Equity Gilt study, which reveals that over the last century there have been 16 ten-year periods "like the last decade" when investors lost money after inflation. But they always "made money in the next ten". And given the past decade has been the second worst of any in the last 110 years, today's "silver lining" is that "the odds look a lot better today than they did ten years ago".
So should you pile into equities? James Montier at Société Générale thinks not. "One of finance's favourite four letter words" – risk – remains a "most misunderstood concept", he says. It doesn't require an investor to obsess over "the pseudoscience of risk management". Rather, as Ben Graham, "father of value investing", observed many decades ago, it is all about judging the likelihood of a "permanent loss of capital"– a hit from which you never recover. This arises from an "unholy trinity" of valuation risk, business/earnings risk, and balance-sheet/financial risk.
1. Valuation risk
Most investors know that expensive stocks are likely to disappoint. But given the steep falls in prices over the past 12 months, surely shares are currently cheap? Not quite – they're cheaper, certainly, says Montier, but not yet at "truly bargain-basement prices". For that to happen the Graham and Dodd p/e ratio – the current share price compared to a moving average of the last ten year's earnings – needs to drop to around ten. That would mean the S&P 500 dropping to just 500 points (from around 830 today). Even applying Graham's rule of thumb that "16 times is as high a price as can be paid for an investment in common stock", things don't look good. Over half of US stocks have a price/earnings ratio above 16, while for Europe and Britain it's 33%. So it's hard to conclude that "valuation risk is absent from equity markets".
2. Business risk
Business risk, which is "considerably more worrying than valuation risk at this juncture", is all about "the danger of a loss of quality and earnings power". And on two measures things don't look good. The first is the dividend swaps market, where prices suggest European dividends could fall off a cliff (see below). Meanwhile, UK dividends could drop by 40% and US ones by around 20%. But risk is also reflected in the ratio of current earnings per share (EPS) to the ten-year average EPS. If the percentage of stocks among large caps with a current EPS of at least twice the ten-year average is used as a "proxy for earnings risk" (ie, the danger that a firm's profits decline), then Britain comes out worst, with over half of stocks qualifying. In Europe it's around 40% of stocks and in America it's a third.
3. Balance-sheet risk
But don't "get distracted by earnings". You should also watch the balance sheet, using Dr Edward Altman's Z score. This bankruptcy predictor is a MoneyWeek favourite. Across America, Britain and Europe it reveals that "20%-25% of companies have a high probability of financial distress". So with a fair bit of carnage still to come, stocks may well get cheaper yet.
Dividend swaps point to disaster
"The outlook for dividends is clearly crucial to the prospects for the stockmarket," says The Economist. The dividend swaps market suggests that that outlook is "distinctly gloomy". This market allows institutions such as pension funds to hedge the risk that future dividend receipts might fall by agreeing to receive a regular fixed payment in return for the dividends actually received.
If dividends receipts fall, the hedge pays off, as the fund gets a higher fixed income via the swap. The trouble is, if everyone expects dividends to decline, the value of the fixed income from the swap – captured by the Dow Jones Euro Stoxx dividend swap index – also falls.
In autumn 2008, the index collapsed from over 140 to around 90 before recovering to just below 100 now. That suggests a "pretty severe outcome", says Eamonn Long of Barclays Capital. Prices imply that the market is expecting European dividends to fall "by two-thirds in two years", with no dividend growth after 2010. Yet dividends doubled between 1931 and 1936 during the last big depression. So either the swap market is being too pessimistic – or share prices "have yet to reflect all the bad news".
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