S&P500 vs Inflation vs PE Ratio over 97 years

The above chart shows the 10 year performance of the S&P500 (blue bars) versus the 10 year average annual inflation (red bars) versus the Shiller PE Ratio at the start of each decade (green bars). There are several notable observations...

• The worst performance was during the 1930s when the US experienced a deflationary environment and PE ratio started very high
• The second worse performance occurred 2000-2009 when PE Ratios started through the roof (> 40) and contracted
  
• Other poor performances typically related to high inflation (1913-1919; 1970-1979) and/or PE ratio contraction (1940-1949)
  

So what do we start 2010-2019 with? A very high Shiller PE Ratio (~20.1), third highest to the start of the Great Depression and Tech Wreck/GFC decades. And, an outlook for inflation that is relatively low due to the very high unemployment that is expected to stay around for some time. The US economy has just seen an economic bounce largely on the back of inventories that are being built back up but this is not a sustainable growth driver and certainly from a sharemarket perspective not a justification for a high PE.

Whislt the US Economy recivers for decent sharemarket returns there needs to be some stronger growth drivers and what these drivers will be is a little unclear.

Interest Rates...relatively stable but a minor dip at the long end

Source: Reserve Bank of Australia

The government bond yield curve certainly expects another 50bps in RBA hikes this year with bonds yielding in the second half of this year trading around 4.3% to 4.4%. But since the start  of the year the yields in longer term bonds have declined a little...this indicates a slight drop in confidence of the Australian economy this year.

As has been widely published, the Australian economy has performed relatively well compared to other developed nations around the world and this is largely thanks to the strong links of the Asian developing economies and their continued hunger for our commodities. With China starting to tighten its credit belt a little there is no cause for alarm, but complacency is not appropriate.

In a week or two, the half yearly reporting season begins and after a few months of relative lack of volatility, I'm sure reporting season may well change that. With US, Japan, and much of Europe in a little economic disarray, the risks still exist, so it should be another interesting year for investors.

Economist Magazine says Australian housing overvalued by 50%!!!

I started reading this week's Economist mag yesterday and the lead article is about the asset bubbles that are appearing all around the world thanks to low interest rates. Article can be found here for subscribers.

In terms of housing the article suggested that the US is at fair value, whilst Britain is 30% overvalued, and Australia, Spain, and Hong Kong are 50% overvalued based on the current level of rental yields. Commodities were mentioed as being overvalued and as with my last post, so too are Emergin Markets.

"Today the prices of many assets are being held up by unsustainable fiscal and monetary stimulus. Something has to give"

I guess I'm off to a bearish start to the day today.

Why shouldn't I invest in China?

There's an excellent article in the 12 Jan Financial Times on investing in emerging markets...found here. The basic message is that there is no correlation between GDP Growth and stockmarket performance, in fact its slightly negative if anything, so be wary when investing in emerging markets.

According to Professor Jay Rittner of the University of Florida,

"Countries with high-growth potential do not offer good investment opportunities unless valuations are low"

Another interesting point made was that in fast growing economies, the companies that end up winning the race may not even be known yet.

"In the 1950s there were more than 100 motorbike companies. The market leader was driven out of business by the cut-throat pricing of a flaky upstart called Honda"

The conclusion in terms of value is that the biggest emerging economy of them all, China, is in a current bubble and valuations are far from low, in both equities and real estate, where valuation metrics are above what Japan was at its peak in 1990. What is frightening with regards to China's valuations, is that twenty years after Japan's peak, its equity market is still trading around 70% lower.

Bottom line, be careful of investing in Emerging Markets and secondly, don't forget Australia's current reliance on China as any bust could be catastrophic for both our economy and markets.

Current thoughts on some investing risks and themes

We have seen numerous investment trends come and sometimes go over the last X number of years whether it be technology, commerical property, Buffettology, CDOs, high yield, hedge funds, mortgage funds, etc, but at the end of the day a balance of the key investment risks wins through....i.e. the risks relating to equity, liquidity, interest rates, credit, currency, and inflation.

These are my current thoughts on these risks and some investment themes...

• Liquidity Risk - forgotten for many years (particularly by the MTAA Super fund, and mortgage investors...remember Estate Mortgage???) but it still exists...forget chasing returns and having liquidity at the same time!!! Know what liquidity you need and hold CASH...not the so-called liquid Asian High Yield securities Basis Capital used for liquidity or even Enhanced Cash funds...CASH in a bank or pure Cash Management Trust that get's it returns from 11am, government securities, and bank bills.
• Equity Risk...guess what? equity risk doesn't just turn up in...equities! It can also be found in corporate bonds, hybrids, hedge funds, property securities, and many others...it is essential to understand the true equity risk a portfolio has and don't push some of that risk into the more conservative asset classes like fixed interest. Equity risk can be scary, is required for growth, and shouldn't substitute for anything else...like...an inflation hedge!...investing in equities is often a poor hedge to inflation as the 1970s showed...high inflation is not good for equity performance at all
• Interest Rate Risk...too many have ignored this one...but it can work in your favour in a crisis and can provide some portfolio stability...stockbrokers should try them some day...the whole "everything correlates to one in a crisis" is absolute rubbish...during the global financial crisis, those who diversified their portfolio with pure interest rate risk (i.e. little to no credit risk) from boring government bonds or conservative bond funds received double digit returns from this risk. During a crisis, investors run to quality and boring government bonds are just that...why don't retail investors want to invest in quality???
• Credit risk...in times of crisis this is highly correlated with equty risk...as a result when building portfolios ensure your credit securities do not result in overweighting the exposure to equity risks. However, always keep in mind that credit securities have a negatively skewed return distribution...limited upside with massive downside...so why not just invest in equities instead and leave the fixed interest to boring governemnt bonds???
• Currency risks...what's the Australian dollar going to do? Answer...absolutely no idea. So what to do? Being unhedged was favourable during the GFC as Yen carry trades returned to Japan and the flight to safety went to the US (yep....good ol' Australian currency wasn't considered that safe!). So perhaps unhedged is the go...however, the reverse was true in the recovery...market timing is very very difficult so if you don't know, and I don't, perhaps 50% hedged, and 50% unhedged is the go for global share allocations. Its difficult to invest in international bonds without being hedged to the Australian dollar...I guess if you want ot investin bonds for their safety and income then currency risk removes the safety aspect and perhapd hedged is best.
• Inflation risks...this is my favourite...bonds are best during deflation but the only investment that (hopefully) guarantees strong performance during high inflation is INFLATION LINKED BONDS!!! Governments around the world, including Australia, are issuing more...woohoo!...let's get on board and reduce inflation risk from our portfolios. Life companies issue inflation linked annuities also...let's look at them as well.
• Commodities can also can be a good inflation hedge also but they certainly carry a few other risks but are worthy considerations as they provide diversification with other asset classes. The only thing with commodities is...they mostly supply and demand driven!...there's not really much added value there, so...good luck with picking supply and demand!!!
• Hedge Funds...these guys carry equity risk and/or credit risk...when markets crash...SO DO Hedge funds...the marketing myth of positive returns in any market has been exposed by the GFC and there's two other things...its very very difficult to get your money out and their fees are so big that they have to take on significant risk to get the return...but at the end of the day if you don't know how a fund invests you don't know the risks so...don't invest in hedge funds!
• Emerging Markets...all the rage because of their economic growth...guess what...there is no evidence that shows high returns from countries displaying high economic growth. If Emerging markets aren't in a bubble today...they probably will be tomorrow...so proceed with caution. 
• Mortgage funds...they're gone for a long time
• Australian economy...had an amazing run and is the leading economy in the developed world but keep this in mind...we're basically a hole in the ground and reliant upon commodities. If the emerging economies falter and decide to stop buying our commodities then look out Australia...things may not be so rosy...just keep it in mind...and stop being so complacent about the Australian economy...I know you are so stop it!
• Property...I think I need a new Post for this one! Stay tuned

Common Sense view on Diversification

On December 30, Robert Jaeger wrote an excellent piece on diversification for the Financial Times (article can be found here) that palces a bit of common sense around portfolio construction as it probably should be. As he mentions...

In the good old days, asset allocation revolved around three main asset classes: stocks, for long term growth; bonds, for income and safety; and cash, for liquidity

 ...unfortunately recent years saw this simple asset allocation rule forgotten. He goes on to say...

cash and plain-vanilla bonds were disdained as “drags on performance”. The equity portfolio evolved to include everything from developed to frontier markets. The bond portfolio evolved to include an alphabet soup of complex products that investors didn’t fully understand. And the new category of “alternative assets” (private equity, hedge funds, timber, et al), many of which are illiquid, seemed to offer a way to enhance diversification without giving up returns.

As we all should know by now (although many are still in denial), these so-called diversifiers failed to diversify during the global financial crisis and we ended up holding portfolios that are illiquid (motrgage trusts, fund of hedge funds, and hybrid property funds) and we have dissatisfied clients.

Now I do believe that investment simplicity reined supreme in 2009  and I hope it continues into 2010. Happy New Year to all!

A Simple 2009 Review and Outlook piece for clients

The year 2009 has turned out to be a significant turnaround year for the global economy and sharemarkets. At the start of the year, the word depression was mentioned often as many economists, investment professionals and politicians thought entering the world’s second great depression was a potential reality. Thankfully, around March 2009, “green shoots” of the global economy started to appear and whilst they haven’t blossomed into anything too beautiful, we have at least witnessed the emergence of many other “green shoots” that have improved conditions in credit markets, share markets, and in the US some positive signs in their housing market.

Sharemarkets bounce...
For investors in sharemarkets, the year 2008 was one they would rather forget and this continued into the first quarter of 2009 where the S&P/ASX200 index bottomed at the start of March. This was the lowest level for the sharemarket since 2003 but despite a lot of paper talk of the market potentially going lower, as is often the case, when the news out of the sharemarket is at its worst prices start to rise. Although the news continued to be bad it wasn’t as bad as expected and between March and October the S&P/ASX200 increased by almost 60%...an astonishing rebound.

The same was true for global shares despite the US, Japan, and Europe’s economic woes that continue today. For the global share investor, returns were also strong double digits. Unfortunately, for the unhedged investor, which is most of us, the strength of the Australian dollar reduced investors global sharemarket gains and many may well see negative performance for the 2009 calendar year.

Bonds subdued...
The economic “green shoots” that contributed to the increase in sharemarkets from March of this year also contributed to increases in interest rates. Unfortunately for the bond investor, an increase in interest rates results in the decline in the value of bonds. For the local bond investor the strength of the Australian economy resulted in some of the strongest interest rate rises in the world and overall returns for Australian bond investors may well be flat. Global bond investors have fared a little better as the overseas economies have struggled significantly more than in Australia and interest rate movement has been minimal to negative. As a result global bond investors may see annual returns between five and ten percent.

Economic Landscape...
The Australian economy has certainly fared very well compared to the US, Europe, and Japan and this is largely due to three main factors:

1. Strength of our banking system which is significantly more conservative than some of the largest banks in the world
2. Strength in our commodity export sector and geographci position close to Asia. This has provided the ability to leverage from the significant growth in China
3. Strength of our government’s balance sheet who in the good times had budget surpluses allowing these savings to be used for the tough times that turned out to be the global financial crisis

Looking forward it is near impossible to know how investment markets will perform but indications are that overall the global economy will be slow as global households continue to reduce debt and high levels of unemployment (which are expected to still rise) provide a drag on consumer spending. Whilst the global economy is improving there remain significant risks as evidenced by the default in its debt payments by Dubai World. Credit markets are far from normal and this is a strong indication that full recovery is a long way off yet.

In Australia, markets have priced in further increases in interest rates by the Reserve Bank with another 0.5% of rises expected by March or April 2010. Rising interest rates is a sign of strong economic conditions so with a bit of luck if there are no further economic shocks there is a stronger sharemarket into the first half of 2010. Given the volatility of sharemarkets this is far from a sure thing but on the positive side, we are coming from the worst global economic conditions since the Great Depression and we are still a long way off our sharemarket highs which were reached in November 2007.

Dubai World Default

Early signs in the US are that the Dubai World default may not really mean too much. Sure US Stocks fell by more than 1%...which isn't too uncommon nowadays...but conversely, US Bond Yields are up suggesting there isn't too much "rush to quality". Time will tell but I'd suggest this is quite a tame reaction.

Nouriel Roubini, famed GFC forecaster, apparently believes this may be the first of more sovereign defults...if so, then that's a different kettle of fish. But at this stage...the US markets aren't convinced.

I hope this chart is wrong...as its a worry

Does this look scary to you? Highest PE Ratios since 2002 for MSCI World and highest for MSCI Australia since before the start of the chart?! I hope these are wrong, as I’m pretty confident the expected growth does not warrant these types of valuations.

You have to love Investment Banks...NOT

Apparently UBS (Investment Bank) says "Myer Float reasonable priced"...see Business Spectator article here.

A few weeks ago I was at a presentation by UBS Global Asset Management's head of Australian Equities, Simon Shields, and he didn't quite say the same thing. In fact he provided some fairly simple advice on floats and in particular the Myer float...of which he was not going to have any part of.

Basically, he said that private equity driven floats, like Myer, are typically set up for failure. The balance sheets and profit and loss statements are stripped bare so that the numbers look great when in fact its a lot of smoke and mirrors. Apparently, Myer's current owner sold a massive portfolio of property and whilst the float may appear to be good value compared to when it was listed before its missing significant assets which doesn't quite make it an apples and apples comparison. As for the P and L, well I don't know if anyone's noticed but Myer is having non-stop sales which boosts short term revenue but invariably creates long term brand damage; and they are operating with a very lean number of staff...to rescue this situation requires Myer to spend more money and thereby threaten profits. The final comment (I recall) from Shields was that the marketing of the float was largely to the Myer One members who, with all due respect, could not be regarded as sophisticated investors so evaluating the appropriate price of the shares might be a little difficult for this group. Bottom line from Shields....avoid floats from Private Equity and accept floats from governments.

Government do the compelte opposite to private equity...they are typically operating companies with too many staff, paying too much for things, thereby providing enormous growth opportunities. Many floats from government are typically monopolies so this also produces some significant advantages.

Anyway, I'm sure there are no surprises that the UBS Investment Bank have a differing opinion to its funds management arm.

Economic Growth does not mean High Equity Returns

One of the more frequent queries I receive is from planners who want to invest their client's funds into high economic growth countries of India, China, and emerging markets. My response is fairly standard in that I wonder why they believe that would provide their clients and the response is typically along the lines of "their growth potential is greater than the rest of the world".

Last week, one of my favourite bloggers, Buttonwood (The Economist), provided commentary on this phenomenon, titled "The Growth Illusion". I know I'm doubling up and perhaps you can read it yourself but in essence, "the faster an economy grows does not mean the faster corporate profits grow and therefore the investor receives higher returns". A study performed performed by Dimson, Marsh and Staunton (they're a few academics involved in the production of Credit Suisse's Global Investment Returns Yearbook this year), showed that there was in fact a "negative correlation between investment returns and growth in GDP per capita, the best measure of how rich people are getting"...so no go there.

A second study showed that the better returns from 1990 to 2005 did not come from the highest growth economies. And a third study showed "no statistical link between one year GDP growth rate and the next year's investment returns".

Another study by Paul Marson of Lombard Odier, showed there is no correlation between GDP Growth and Stockmarket returns of Emerging Markets.

The most likely reasons for all of this rests with a few reasons stated in the Buttonwood blog...

• the potential is already recognised and factored into prices so that they are bid up to very high levels
• the stock market does not represent a country's economy and vice versa
• "growth is siphoned off by insiders at the risk of shareholders"

The best recent example I can think of is China. It may have had one of the best growth rates in 2008 but the sharemarket still crashed by 70%. With all of this good news flowing through for the month of August China's stockmarket was still down 20% (albeit up by 70% beforehand). Maybe investing in a growth economy will produce the good or maybe it won't, but as the first point above alludes to...everyone knows this so why wouldn't it already be priced in?

Mutual Fund Theorem - Ignored by most financial advisers

According to John Campbell, Professor of Finance at Harvard, “academic finance has had a remarkable impact on many financial services. Yet, financial planners offering portfolio advice to long-term investors have received curiously little guidance from academic financial economists”.

A case in point is the Mutual Fund Theorem, which was developed by Nobel Laureate, James Tobin in 1958. The mutual fund theorem is a very simple approach to investing based around Harry Markowitz’s efficient frontier framework suggesting that all investors should hold only one portfolio of risky assets. This one portfolio can then be adjusted for the conservative investor by adding risk free assets (or cash), or can be geared for the aggressive investor.

Figure 1 shows the efficient frontier and the Capital Market Line (CML) which is drawn from the expected return of Cash through the tangent of the efficient frontier (represented by the Optimal Portfolio). Whilst it is not a perfect representation of reality, it demonstrates the possibilities that:

• By adding cash (or a risk free asset) to the optimal portfolio (which contains bonds, equities, etc) it is possible to achieve a high return for less risk than a portfolio of bonds…this is the benefit of diversification


• Gearing the optimal portfolio has the ability to achieve a high risk-adjust return than a portfolio of 100% equities. Most of the high growth portfolios include only equities (which clearly may be less efficient than a geared diversified (or optimal) portfolio)

Whilst most if not all financial planners and advisers are aware of the Markowitz efficient frontier and the derivation of the optimal portfolio (i.e. the portfolio with the highest expected return per unit risk), the use of this very simple part of modern portfolio theory has seldom been put into practice. Financial planners throughout the world typically look to personalise portfolios for individual clients based on their risk profile, income and growth needs and most likely looking to build portfolios that are on the efficient frontier. As Figure 1 shows, in theory this may not be the most efficient approach and is potentially creating unnecessary work that adds little to no value in terms of what matters to investors the most, investment returns.

From a practical financial planning perspective, adding cash or gearing an “optimal portfolio” certainly makes things a lot simpler.

Now whilst every investment professional in the world attempts to design an optimal portfolio within their constrained investment universe, we all know that it is impossible, but of course, it doesn’t stop us from trying. For the retail investor the optimal portfolio is often regarded as the “balanced” portfolio, which has a diversified allocation across all available asset classes whether equities, bonds, real assets, etc.

So to really keep portfolio construction simple, recommend the “balanced” fund for the balanced investor and add cash for the more conservative investors and gear into the balanced fund for the growth and high growth investor.

Some of the challenges with implementation include, choosing the optimal portfolio; the limitations of implementation in various investment vehicles such as superannuation where gearing may be difficult; or simply getting cost effective gearing.

Overall, this theorem should provide some food for thought next time a portfolio is constructed and some questions to ask before building the next “tailored” portfolio could be…can a geared diversified portfolio be more efficient than 100% equities or should the client really be out of equities just because they are conservative? At the very least, the Mutual Fund Theorem demonstrates the best method to manage risk is diversification and diversification across all asset classes should be considered irrespective of the investor’s risk profile.

An Argument for Global Diversification

With Australia having the second worst returns amongst the above-mentioned OECD countries this clearly shows the benefits of having a portfolio that was diversified globally during 2008. Even in the USA, the originator of the global financial crisis had better returns than in Australia.

A simple economic/financial update for some planners

Over the past few months the global economy has seen the emergence of “green shoots”. As implied, there are indications that the global economy may be turning a corner. Like turning around a super tanker, turning around the global economy will take a long time and these signs aren’t so much an improvement but indicate a slowdown in the deterioration of the global economy. For example, in the US only 345,000 jobs were lost during May which is around half the average monthly decline of the previous six months. US Unemployment is still increasing but not at the rate it previously was.

Other positives include the gradual decline in the cost of credit (remember the Global Financial Crisis started as a credit crisis), stabilising financial markets, perceived future demand resulting in increasing commodity prices (Oil increased by 48% in USD terms over the past 3 months), and improving consumer confidence.

In Australia, our unemployment stands at 5.7% and the Australian Bureau of Statistics announced that we avoided a technical recession to the quarter ending March 2009 with positive real GDP Growth of 0.4% thanks to declining imports.

For the Australian sharemarket investor, returns for the 3 months ending May 2009 have been spectacular with the broad All Ordinaries Accumulation index increasing by a little more than 17%. Overseas sharemarkets also provided strong returns and the major sharemarket indices of the US, UK, and Japan increased by 25%, 15% and 25% respectively. With the Australian dollar appreciating over the same 3 months against the US Dollar, Pound, and Yen, by 25%, 11%, and 22% only the hedged international investor experienced the strong international gains as the strength of the Aussie dollar most of these returns.

The perceived improvement in the global economy combined with large budget deficits all around the world including here in Australia, government bond yields increased substantially. This means that investment returns for the bond investor were relatively weak (as high interest rates mean lower bond prices). The UBS Composite Bond index had a slightly negative return of -0.6% for the 3 months to May 31, and the global fixed interest index, JP Morgan Broad WGBI (AUD) Hedged Index, returned only 0.43%.

Whilst the short term sharemarket gains indicate positive signs for both the Global and Australian economy, there are still significant signs of weakness. Unemployment both here and overseas is still increasing which will continue to dampen demand and force households into increased savings instead of spending. Business investment is weak and companies continue to struggle, as evidenced with the recent collapse of General Motors and Chrysler in the US, and two of the largest agribusiness companies in Australia, Timbercorp and Great Southern. The last few months have shown the risks of being out of the sharemarket when everything appears to be at their worst. For investors, sticking to a portfolio with the risk profile designed to help achieve financial goals is essential.

Style Biased Index Funds - the Future of Managed Funds

Index funds were born out of modern portfolio theory which suggested that the highest risk-adjusted return should come from purchasing the market portfolio. As it is impossible to purchase market as a whole, the index fund effectively replicates the market by purchasing a large proportion of the market with each stock’s weighting proportional to its market capitalisation. Around the world, this method has been replicated across all asset classes. In Australia, the available index funds are mostly limited to the major asset classes. Some geographic index funds, like BRIC, China, S&P500, etc are also available as well as specific sub asset classes like Global Credit index funds. There is little doubt index funds provide a low-cost way of providing investors exposure to specific markets without the active management risk of the 'bad bet'.

The current bear market has resulted in many investors looking for simplicity, transparency, and low costs and index funds satisfy all criteria. Whilst many wealth and funds management companies have suffered during the Global Financial Crisis, index funds have thrived. Barclay’s have released a wide array of listed international index funds, Vanguard also released some exchange traded funds and only yesterday announced they are moving into larger premises and hiring an additional 8 sales professionals. And now, in Australia the index fund has another variety with the introduction of Research Associates' Fundamental Index (RAFI) and various investment products linked to this index approach.

In recent weeks I have received more queries regarding this new index method than anything else (except the ubiquitous structured product). It is marketed as an alternative to traditional index funds and its difference is that it doesn’t use a company’s market capitalisation as the weighting determinant but uses measures such as sales, profits, dividends, amongst others. The founders of RAFI believe traditional indices overweight overpriced stocks and underweight underpriced stocks and they believe this new method overcomes this flaw. Despite the strong support the fundamental index has received locally and overseas, there have been many critics.

The main criticisms of the Fundamental index method are that it resembles an ‘active value strategy in disguise’ requiring numerous subjective decisions around stock selection. As a result of this, many believe the fundamental index is not efficient when compared to multi-factor quantitative strategies. Even if these arguments are true, at this point in time they are fruitless arguments in Australia because accessing passive strategies that are different but priced similarly to traditional index funds are few and far between (the one exception is DFA which is not necessarily easy to access as an adviser). At least the fundamental index investments are around 40bps cheaper than active equity managers and this is a significant cost saving over the long term. With this cost saving if its stated return premium is due to a value bias then as long as this bias/risk is understood there is nothing wrong with that. With the exception of the DFA funds, to achieve a value bias typically costs a lot more than the RAFI funds.

Back to the critics opinions…belief in the so-called efficiency of multi-factor quantitative strategies creates an opportunity in the Australian funds management industry. Globally, it is widely acknowledged that over the ‘long term’, equity portfolios biased towards...

• low price to book,
• small companies, and more recently,
• companies exhibiting performance momentum (i.e. performed well over the last 3 to 12 months)

...outperform traditional indices on a risk-adjusted basis. Accessing these style biases in low cost ways cannot easily be achieved in Australia for the retail investor. Perhaps this is the future of equity index investment in Australia.

For the active manager style biased index funds will be a significant threat. The active manager will have new truly investible benchmarks and they will have to prove their skill against low cost funds with similar style biases. This in turn could reduce costs due to increased competition and only the strong will remain. The active manager often hides behind their style bias when underperformance occurs, however, with style biased index funds in direct competition this will not be an excuse.

The introduction of the fundamental index products are an excellent addition to the Australian managed fund scene and moving forward I look forward to seeing more low cost, style biased index funds to provide more efficiency and choice for the retail investment portfolio.

Market Valuation Update

Source: RBA

The rise in global sharemarkets in the last 2 months has seen the PE Ratio increase from its bottom at around 10 to around 12 to 13. As the above chart shows this ratio valuation level is not too different to the average PE Ratio in the 1970s and for Australia, the 1970s and 1980s.

With the global adn local economy still forecast to shrink in 2009, company profits expected to drop significantly, the current PE ratio still does not look cheap and significant downside risks remain on valuation alone.

Risks of Direct Equity Portfolios

This week my latest education article was published in IFA magazine. Basically it summarises the amount of additional downside risk a direct equities portfolio with a small number of stocks takes on compared to portfolio with a large number of stocks. There is myth that concentrated stock portfolios are more likely to outperform managed funds, an index, or a larger stock portfolio. This myth appears every bear market and must be exposed for what it is...rubbish.

If you can’t get the magazine, never mind as the article can be found by clicking on the following link... http://tinyurl.com/dmq7da

Putting this bear market in perspective

source: www.dshort.com

This is US data only. Compared to the other serious bear markets the recent rally is pretty standard stuff and appears to be no more than the usual short term noise in the market. This bear market has so far performed similarly to the 1929 crash so far but lets hope it doesn't go for as long or as low. The 1929 crash lost close to 90% from its previous high...ouch.

Is the market cheap?

The above chart is a couple of weeks old now but is showing the market PE ratio to be around 11 (so its probably 12 now). As the chart shows this is a PE ratio that was pretty much the average throughout the 70s and early 80s. Now a PE of 11 is an earnings yield of 9% and if we expect negative growth of say 1% then we're left with an 8% earnings yield over the next 12 months. With the government bond yield at around 3% is 5% really a sufficient risk premium? With BBB rated corporate bonds with an average credit spread of at least 5% I'm not really sure the current PE ratio really stacks up as attractive given the incredible headwinds Australian companies are facing...many may say the market's cheap and maybe a PE of 11 (or 12) is cheap...but not yet.

Don't be deceived with low valuations

The lcaol sharemarket continues to show some very low PE Ratios and very high dividend yields which look terribly attractive. As the following chart shows, looks can be very misleading while analysts continue to sharply downgrade forecast earnings.

Interesting fact

Apparently the month of March provided the best monthly return for the S&P500 since the Great Depression. I don't know what this means but I'd be surprised if it happens again in a hurry.

Volatility 'and Fear' Creeping up

Source: Bloomberg

The above chart is everyone’s latest favourite, the VIX index (otherwise known as the Fear Index). Today it closed at 57, up from 50 at the start of the day, and as can be seen it is creeping back up towards those October and November levels. Given the S&P500 closed down today by more than 5%, its no wonder the VIX is up but the big question is…does this mean there is more pain to come?

So what is the VIX index?...its a mathematical calculation of the implied volatility taken from S&P500 option contracts that are sold on the Chicago Board Options Exchange (CBOE). It is an expectation of the S&P500 market volatility of the next 30 days.

Short Selling Ban

This morning, The Sydney Morning Herald suggested that when the short selling ban is lifted AMP, NAB, QBE and Wesfarmers are stocks that are “most likely to come under pressure”. If this is true, what on earth do hedge funds or short sellers know that the rest of the “long only” funds management industry, stock analysts, and shareholders do not? I’m sure the answer is nothing. These stocks are some of the most researched and widely held stocks by fund managers in this country and if they were seriously overvalued and warranted short selling then existing shareholders would be selling anyway.

Whilst equity markets may not be perfectly efficient, they are mostly efficient most of the time and adjust to news quickly. The biggest price drop amongst Australian stocks in many years occurred whilst the short selling ban was in place. The reality of hedge funds is that on average they are no more skilled than any “long only” fund manager so the likelihood of these stocks being short sold to significantly low prices is ludicrous. Equity prices will only be driven lower by worse than expected news on the company, sector, industry, and/or economy…not short selling alone!