Thursday, October 16, 2008

Blowing Off The Froth

Moments of madness always have a price

Much commentary this morning about the further slide in stock markets. What's going on? Does it mean the bank bail-out has failed? What's Plan B? We need action now!

From a taxpayer perspective this is careless talk. And careless talk has a nasty habit of costing taxpayers whole shedloads of money. Having already bailed out the banks at a combined global cost of £2 trillion, the last thing we need is to have our politicos stampeded into somehow (how?) bailing out the equity markets as well.

There's no doubt that stock markets are signalling a serious recession. And there's no doubt their decline will feed back into that recession and make it worse - after all, a lot of wealth is being wiped out before our very eyes (some of it belonging to Tyler, we might add).

But we need to understand the markets are still blowing off the accumulated froth of the last 15 years.

As always it's helpful to take the long view. The chart above shows a widely used valuation measure of the US equity market*. It's the ratio of the market price to the underlying earnings of the companies whose shares are being traded - the Price-Earnings ratio (PE ratio). Note that this PE is based on a trailing average of real earnings over the previous 10 years, in order to smooth out short-term fluctuations*.

[For those unfamiliar with the PE ratio, think of it as being the cash price you'd have to pay to own £1 (or $1) of annual company earnings; so a PE ratio of 20 means you're paying £20 for £1 pa of earnings, whereas if the ratio falls to 15, you only have to pay £15 - ie the market has got cheaper. Of course, this can never be more than a rough guide because in reality we don't actually know what future company earnings will turn out to be - which is why the chart above uses a moving average of the previous ten years earnings].

As we can see, over the entire 127 year period for which we have data, the average PE ratio on the US equity market (S&P composite index) has been around 16. And after yesterday's sell-off, the market closed on a PE of 14.4.

That's good. It means we've returned to the realms of sanity after the ludicrously high market valuations reached under Brown mentor Sir Alan Greenspan (the "Greenspan put" - see this blog). But unfortunately, it doesn't mean we've hit the bottom.

Because we can also see that the equity market undershoots as well as overshoots. And given the current circs, it would not be at all surprising to see at least one more major downward lurch. A return to the 70s would suggest another 30% off current market levels.

It's painful. No doubt about that. But ideas that governments can somehow ride to the rescue of equity markets are a delusion. Short of wholesale nationalisation and the closure of financial markets, we equity investors simply have to accept what's coming.

Sustainable economies cannot be built on financial froth.

(And at some stage there will be some stellar bargains out there).

PS Should central banks take more account of asset bubbles in setting monetary policy? With hindsight, everyone now agrees they should. Just as everyone now agrees having the Bank of England target an inflation measure that excludes housing costs is lunacy. But let's not kid ourselves that's a painless panacea. For example, it would have meant the Fed keeping interest rates higher in the early years of this decade and almost certainly triggering a global recession then. Although it must be said it would have been a whole lot milder than the winter we now face.

PPS Talking of Plan B, it's good to see Marks and Sparks' smug PC Plan A campaign to save the planet ("because there is no Plan B") has been surreptitiously dropped. The most visible bit of Plan A was to charge food customers 5p for plastic carrier bags. But in a central London M&S yesterday I - along with every other customer - was given a free plastic carrier in which to cart off our salt and cholesterol supplies. Apparently, they've had many customers dump their shopping and walk out rather than pay the 5p - free carrier Tesco Metro is just 2 mins walk away. Aren't markets wonderful.

*Footnote: the US equity market data comes from the website of Prof Robert Shiller, the world's foremost expert on speculative asset bubbles, and author of the must-read Irrational Exuberance. Shiller's measure of earnings is based on average inflation adjusted earnings over the previous ten years.


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