For several years, writing about investment has been like watching a cricket match in a greenhouse. You know things will get broken – you just don’t know how bad the carnage will be.
That outlook doesn’t make you very optimistic. The fact that it turned out to be right is no consolation. So it’s been quite a shock to find myself turning almost bullish over the last few weeks.
I’m not yet convinced that this bear market is completely over. But for the first time in years, almost all equity markets – as opposed to specific stocks – look like a fair long-term bet. If history is any guide, returns over the next few years should range from acceptable in the US to pretty spectacular in parts of Asia …
The S&P 500 is almost cheap
Take a look at the chart below for the S&P500. It shows a valuation method developed by Irrational Exuberanceauthor Robert Shiller: the ten-year cyclically-adjusted price/earnings ratio, which is the p/e ratio based on inflation-adjusted earnings in the previous ten years, rather than just the current year’s earnings.
The chart also shows the average annual total return (i.e. including reinvested dividend payments) over the following ten years. The total return is shown upside down to make the relationship easier to read.
As you can see, the connection appears to be quite strong. That’s no surprise. After all, in the long-run a share is a claim on the assets and cashflows of a business. The cheaper you buy that share (i.e. the lower the p/e ratio) the better your long-term returns are likely to be.
As you can see, so far in this bear market the cyclically-adjusted p/e hasn’t got down to the rock-bottom lows that we’ve seen before. I think there’s a good chance that the S&P will ultimately slide lower in valuation terms, especially given the protracted deleveraging America will go through. That could mean another plunge later this year or it could take the form of a sluggish recovery over several years.
However, the chart suggests that even at today’s valuations, long-term returns are likely to be respectable. That’s a sharp turnaround from 2006-2007, when it was obvious that long-term returns would be dire. It’s certainly not time to go all-in on equities, but steady buying over the next few years will probably pay off in the long run.
Asia looks cheap too – as far as we can tell
Since this is an Asia-focused article, you may wonder why I’m looking at the US market instead. The answer is simple: the long-term data for America are much better than the rest of the world, since it’s the world’s largest market and the one that researchers study the most. Doing similar work on the rest of the world is much harder.
Still, I’ve managed to dig up data going back a few years for Hong Kong’s Hang Seng index, and I’ve done a basic version of the same analysis on it. You can see the result below (in this case it’s p/e ratio that’s shown upside down, not the total return).
There are a couple of differences. A nine-year cycle seems to fit a little better than a ten-year one, probably because Hong Kong had two huge, very sudden bubbles exactly ten years apart in 1987 and 1997. And I’ve used the logarithm of the nine-year p/e ratio in an effort to capture the effect of compounding dividends better.
But the principle is the same and the relationship seems to echo the S&P: returns are high when the starting p/e ratio is low and vice versa. With Hong Kong valuations now very fairly low, this points to good returns over the next decade.
Forecasting a depression
Still, what if we’re facing a second Great Depression or a Japan-style ‘lost decade’? Surely normal valuations are useless and we’re facing much bigger slumps than this model suggests?
Not necessarily. As you can see in the first chart, the S&P analysis includes both the Great Depression and the miserable bear market of the seventies and still forecasts returns reasonably well. For Japan, I ran the same analysis on the Topix and you can see the results in the chart below.
Again, this kind of model did reasonably well in spotting the slump. The rising p/es of the late 80s accurately predicted weak returns over the following decade. It breaks down a bit around 1992-1996, forecasting high returns when in reality they fell back. This reflects the fact that Japanese corporate earnings in that era were often complete fiction, as companies were sitting on vast unacknowledged losses from the asset price bubbles. Realistic earnings would have pointed to the much worse returns that we saw.
This has been a brutal bear market
When thinking about the worst-case scenario, we need to remember that this has already been a spectacularly brutal bear market. The chart below shows the biggest peak to trough slumps in US equities since 1800. As you can see, this has been the fourth-biggest rout on record.
While I’ve broken out the 2000-2002 crash and this current one individually, it may make sense to take the peak of the equity bull market as being 2000 rather than last year. In that case, equities have declined by 63% in real terms – on a par with 1906-1921 and 1852-1857 and only really exceeded by the Great Depression.
In short, markets seem to be allowing for most things short of total meltdown. And while I’m a natural pessimist, forecasting a second Great Depression seems excessive. Indeed, there are already small signs that the freefall in the global economy is slowing.
Better news on exports and trade
In last week’s email, I mentioned a few pieces of encouraging news (see here for the full list). One of them was a strong pick up in Korean exports in February. Well, Korea’s numbers for March are now out and as you can see below, exports rose again month-on-month. The pick up was towards the bottom of what we expect in February-March – but that’s no real surprise after February’s rebound. All told, this is encouraging.
Similarly, there’s a possible improvement in the container shipping market, as you can see below. Rates continue to tick down and are likely to be very depressed for a while given the oversupply of ships. But the percentage of ships idled looks like it might be peaking at around 11.3% of the fleet (for comparison, this peaked at 3.2% in the 2001 recession, showing again how bad things are this time). That suggests that the global trade contraction may be easing.
Now, this certainly isn’t the end of the recession. Things will be grim for a while. All we’re looking for is the first hints that the plunge may be stabilising. And it seems we’re finally finding some.
Of course, this could be a false start. There are very few good monthly data series stretching back to 1929, but we have industrial production numbers and the stock market. As you can see in the chart below, both suggested that things were stabilising in early 1931 – and we know how that turned out. It’s important to bear this in mind and avoid jumping to conclusions that the worst is behind us.
Financial collapse is highly unlikely
That said, if you are concerned that history may be repeating itself, there’s a slightly more optimistic conclusion to take away from what happened in 1931. It’s likely that there was a chance to stop the spread of the Great Depression that year.
Around the time that American industry was apparently picking up, a wave of bank failures hit the US and continued for the next three years. That may well have destroyed the nascent recovery. Meanwhile, Creditanstalt, the largest bank in Austria, failed in May 1931, creating panic throughout the financial centres of Europe and undoubtedly making the depression in Europe far worse than it would otherwise have been.
It’s unlikely that anything similar will be allowed to happen this time. Even if you take the collapse of Lehman Brothers as a Creditanstalt-type event, the subsequent response has been very different to the thirties, when France blocked an international loan to Austria for political reasons.
It’s now clear that no more key institutions will be allowed to fail if governments can prevent it. While vague, the commitments at the G20 meeting to increase the IMF’s funding and support trade finance still mean that the risks of international contagion and banking system collapse are much lower than they were in the 1930s – or even six months ago.
Indeed, while there are always plenty of reasons to criticise policymakers, we need to bear in mind that they are doing a lot more than their counterparts did in 1929, in terms of financial system support, fiscal stimulus and monetary policy. They’re also acting much faster than Japan did in the 1990s, when the government took until 1998 to recognise the banking system’s problems and inject new capital.
Things aren’t great, but they’re probably better than they could be. Even more importantly, they’re probably better than the market suggests in this climate of fear, deleveraging and forced selling. And in the long run, returns on equities should reflect that. The time to turn cautiously bullish isn’t far away.
In this week’s other news …
| Market | Close | 5-day change |
|---|---|---|
| China (CSI 300) | 2,576 | +3.1% |
| Hong Kong (Hang Seng) | 14,546 | +3.0% |
| India (Sensex) | 10,349 | +3.0% |
| Indonesia (JCI) | 1,500 | +2.6% |
| Japan (Topix) | 831 | +0.8% |
| Malaysia (KLCI) | 907 | +2.4% |
| Philippines (PSEi) | 1,983 | -2.8% |
| Singapore (Straits Times) | 1,821 | +4.3% |
| South Korea (KOSPI) | 1,284 | +3.7% |
| Taiwan (Taiex) | 5,530 | +2.6% |
| Thailand (SET) | 443 | +0.5% |
| Vietnam (VN Index) | 297 | +3.4% |
| MSCI Asia | 78 | +1.0% |
| MSCI Asia ex-Japan | 310 | +3.0% |
In Malaysia, Najib Razak was sworn in as the new prime minister, replacing Abdullah Badawi, whose stint was generally seen as well-meaning disappointment. The new prime minister faces a difficult challenge in holding together the governing Barisan Nasional coalition in the face of growing discontent among the electorate and party infighting. Najib is a controversial figure whose opponents have long accused him of corruption and links to a murder; he denies all allegations.
The dollar certainly isn’t dead yet, but China seems to be moving to make the renminbi a more significant international currency. Last week, Beijing signed a $10bn currency swap deal with Argentina, following similar argeements with Belarus, Hong Kong, Indonesia, Malaysia and South Korea in recent months The deals will allow trade between China and the swap partner to be settled in renminbi; the economic impact will be limited, but by-passing the dollar in this way has some symbolic value.
And online game operator Changyou became the first company to float on the Nasdaq this year and the first Chinese firm to list in the US since August. Chagyou, which gets over 90% of its revenue from a single game, raised $120m in a spin-off from internet portal group Sohu.com. The offer was reported to be fifteen times oversubscribed.
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