Should you really get back into the market?
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MoneyWeek Editor-in-chief
Merryn Somerset Webb Sep 29, 2009
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Stay out of the water for now...
I had dinner this week with old friends from my Japanese stockbroking days. We talked, predictably, about markets.
These friends, like many with Japanese experience, were clever at the beginning of the financial crisis: they got out of equities and into cash early and quickly. But then – in spite of being pretty sure they should – they couldn't quite bring themselves to move back in to equities at the beginning of this year.
Again, like many others, they are still out – this rally has kept going on remarkably low volumes. That made the question of the evening a simple one: is it too late?
The very fact we were having the conversation suggests not. A really good rally such as this needs only two things to keep going: the continued capitulation of the bears and a clever-sounding justification of some kind.
This one certainly has the former – it is tough being out of the market at times such as this and the statistics tell us that, both here and in the US, private investors have started to pile in.
It has the latter, too. But I don't buy the V-shaped recovery argument for a new bull market.
The two sectors driving the recovery in the US, such as it is, are housing and cars – both of which have been the recipients of a (surely) unsustainable level of government support.
In the UK, meanwhile, consumption is falling, unemployment is rising, the housing market is still a mess, our banks are in no mood to lend and public spending is soon to start contracting at speed.
Even so, you don't need to believe in recovery to believe in a bull market. You just need to believe in low interest rates.
Back in Japan's bubble days, we used low interest rates to justify pretty much any level of valuation and I'm beginning to hear the simplistic arguments of late 1980s Tokyo rolled out again – this time with reference to western markets.
Consider the price/earnings ratio (p/e ratio). Some might say that on a current p/e of 14 times, the FTSE is beginning to look a little overvalued. But think about what a p/e ratio, calculated by dividing the current price of a share by its earnings per share, actually tells you. It tells you how many years it will take for the company in question to make back in profit – for you – the amount of money it cost you to buy the shares in the first place. So, in this case, 14 years.
But then look at the current risk-free rate – the return you get on cash. With the Bank of England base rate at 0.5%, it will take you 200 years to make back what you invest if you put it in cash. That makes 14 years look pretty good doesn't it, even if equities are a little riskier than cash?
Extrapolate out a bit further and you could make a p/e of 50 times look just fine. Much the same goes for the dividend discount model of valuing shares – the lower you assume interest rates, the better the dividend payments appear and the cheaper the stock market looks.
The thing about these justifications, of course, is that they mean nothing. All stock market valuation methods are entirely subjective. A historic p/e ratio is useless because it tells you about the past, not the future.
A prospective p/e ratio should theoretically be more useful in that it tells you what might happen in the future. But it probably isn't. Why?
Because it depends on what your favoured analyst thinks earnings will be next year, and the year after that, and the year after that. And he hasn't a clue.
At the same time, a dividend discount model of any kind depends on your analyst's guess about where interest rates will go and where dividends will go over the next five or ten years. Once again, he hasn't a clue – now more so than ever.
Finally, note that the 'low interest rates mean rising stocks' argument, however good it sounds, doesn't necessarily work. The collapse of all asset prices in Japan in the 1990s saw a complete breakdown of the assumed – and in some ways, perfectly rational – relationship between interest rates and valuations.
So back to the question: is it too late to get in? Given all the money not in the market that wishes it were in the market – and all the justifications its owners can give for putting it in – it might not be.
Hedge fund manager Crispin Odey, who is usually right (something I wish I had remembered earlier this year when he called the start of this monster rally), said this week that, while markets are entering a bubble phase, it is a phase that could easily last to the end of the year thanks to the Bank of England's ongoing affection for monetary easing.
But I'm not sure that means we bears should go in for even temporary capitulation. A look at the chart of the Nikkei should work as a reminder of how savagely bear market rallies can end: every rally for the last 18-odd years has been met by a collapse of greater magnitude, leaving the index, even now, at around a quarter of its peak value. My friends have decided to stay out.
• This article was first published in the Financial Times
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