LONGING THE DOW + FTSE = MASSIVE RALLY AHEAD-part 6(into the new year)

Lex: Equity markets
Published: January 1 2002 20:16 | Last Updated: January 1 2002 20:38



Much else may have changed on September 11, but it took until September 21 for the bear market to end. Equity markets by then had been falling for 18 months - the longest decline since 1980-82, and the deepest, from peak to trough, since 1973-74. Since then, the S&P 500 index has rebounded by 20 per cent. Investors, anxious not to miss the economic turnround in 2002, have bought cyclical and high beta stocks, and dumped their defensive holdings. The result may be that the cake has been eaten before it was fully baked.

On absolute measures, equity valuations in much of the world, and especially in the US, look startlingly high. The I/B/E/S 12 month forward price/earnings ratio for the FTSE World index, at 20.6, is still in the very upper range of its recent history. The forward p/e for the S&P 500 stands at a vertiginous 21.68 times. These ratios depend on forecasts for 2002 which predict an early and pronounced recovery in earnings. Plug in JP Morgan's more pessimistic forecast that US earnings growth for 2002 will be essentially zero, and the multiples look more stretched still.

A simple dividend discount model provides little comfort. Take the current dividend yield of the S&P 500, at 1.37 per cent, and add, say, another percentage point cent to adjust for share buybacks as a means of distribution - although some buyback programmes have been cut as companies feel the pinch.

Using a real risk-free rate of 3.6 per cent, and long run economic growth of 3 per cent, this adjusted yield implies an equity risk premium of just 1.77 per cent. A similar exercise for the UK and the eurozone, with no adjustment for buybacks, using a long run growth rate of 2.5 per cent and risk-free rates of 2.9 per cent and 3.4 per cent respectively, throws up implied equity risk premia of 2.15 per cent and 1.49 per cent. These are uncomfortably low.

Dividends may have come back into style, in reaction to the excesses of the dotcom era. Nevertheless, this calculation probably provides an unduly pessimistic outlook. More support for equity valuations comes from relative measures such as the earnings yield ratio. On this measure, Europe, at 1.17, and the UK, at 1.22, would appear still to offer some value. The US, at 0.9, would not.

Academics, on the assumption that equities are a real asset and bonds a nominal one, snort at such comparisons. Nevertheless, many asset allocators have used the earnings yield ratio or variants of it, and made money. Over the past 20 years, its worst failure as an indicator was its premature sell signal during the technology boom of the late 1990s.

Fund managers, according to Merrill Lynch's global survey, now feel that equities are just about fairly valued. That assessment, however, is based on a mean expectation of 6 per cent earnings growth next year - with almost half believing earnings will grow by 10 per cent or more. These earnings expectations are considerably more modest than the predictions of sell-side analysts, but they still leave plenty of room for disappointment. If that happens, then the bear market may turn out not to have ended quite so decisively as it appeared.

Bonds

The downside risks to equities suggest there may be value in bonds. Investors worried about missing the stock market recovery have dumped bonds as well as defensive stocks. The yield on 10-year US Treasury bonds, at 5.04 per cent, has risen by a fairly startling 83 basis points since the end of October. The yield on a synthetic eurozone 10-year benchmark has risen by 63 basis points over the same period, also to 5.04 per cent. As with the rise in equities, the fall in bond prices looks somewhat half-baked.

It is certainly odd, given past experience, for bonds to be anticipating a turn in the economic cycle so early on. Forward markets suggest very little expectation of further US and eurozone rate cuts and a rapid shift to higher interest rates. But there is at least a coin-flip's chance that the Federal Reserve will deliver another rate cut. The same can be said of the European Central Bank, even more difficult to predict.

The same reasons that suggest caution on US equities - the prospect of a sluggish economic recovery rather than the sprightly one priced in and optimistic valuations - point to value in Treasuries. Inflation is on a downward trajectory, helped by rising US unemployment, falling energy prices and spare capacity in the US and worldwide. All that suggests that the Fed need not rush to start raising rates this year.

The eurozone bond market - as with stocks - presents a more modest version of the same picture. European bonds have not been sold off as sharply as US Treasuries. US bonds look better value. The coming of euro notes and coins, however, could support a rally in eurozone bonds.

Among currency forecasters, euro bulls might be dusting off last year's predictions of the euro achieving parity with the dollar during 2001. As it turned out, the euro slipped by another 6 per cent against the dollar last year. The dollar remains overvalued on conventional measures: if expectations of a strong US recovery are dented, that could mean a setback for the greenback.

The experience of the 1998-99 period was that the Fed was too slow to take back the emergency rate cuts that followed Russia's default and the collapse of Long-Term Capital Management. That means that the central bank might this time start to take back some of its terrorist attack-related emergency action, even while the inflationary outlook remains benign. Even then, market expectations for central bank tightening look overly aggressive.

With equities priced for a healthy recovery, the best prospect in the US would appear to be one of modest positive returns, with perhaps slightly better prospects in Europe.

Corporate debt, meanwhile, having allowed a greater margin for error than stocks, offers the prospect of a better return than equities in the event that a strong global recovery does materialise.

If earnings growth is weaker than expected, this will not only spell disappointment for stocks, but also credit risk will become more pressing. With government bonds pricing in a decisive turn in the interest rate cycle, the considerable uncertainty that remains about the shape of the US recovery means that, at the start of a new year, bonds look a better risk-adjusted bet than equities.