Markets not out of the woods yet

Friday 1st March 2002

Overvaluation has become an almost universal cause of concern running right through the markets.

Shares, particularly those in the US, are accused of being too expensive. Bonds look vulnerable once central bank interest rates rise again. The US dollar seems almost universally thought overpriced by market commentators.

The latest storm over company auditing practices post-Enron is a variation on the overvaluation theme. An earlier version, one that snagged Telecom recently, was the tendency of IT companies during the Nasdaq bubble to book the whole value of a forward contract into one tax year. People were none too concerned about accurate valuations during the boom, just as they weren't in the leadup to the 1987 crash. And as they are doing now, so they were fingering accountants back in the earlier bust. History repeats itself.

One remarkable phenomenon of the IT bubble occurred when Warren Buffett, the world's most renowned value investor, apologised to Berkshire Hathaway shareholders for missing the tech boom because he didn't understand the companies involved. That was just before the bust. Post-crash, Mr Buffett's confidence was restored and he crowed to his investors about his sage wisdom in sticking with value. If Mr Buffett could go flaky - albeit briefly - on value investing, even greater extremes must have arisen among the less conservative.

Much of that incaution is in payback mode with stocks and probably has not worked itself out yet, despite low interest rates around the world. Much has been made of how sharemarkets have got back to around pre-September 11 bombing levels as if this is a good thing. Such a view overlooks that even before September 11 there were warnings that, despite a prolonged bear market, many US stocks were still overvalued.

An Economist article on September 8, 2001, headlined "Driven to the same depths?" questioned whether the US sharemarket would follow Japan's into a deep slump.

The magazine quoted Jeremy Grantham, of Grantham, Mayo, Van Otterloo, saying US stocks had excessive price/earnings multiples. He said the long-term historic norm for P/Es was 14 over the past 100 years. He believed possibly 17-18 could be justified but that the average level of 23 was too high.

On his reckoning, the S&P 500 index would have to drop 40% over the next decade, which predicts a prolonged bear market of the type that has occurred before and is seen most recently with Japan's stockmarket.

Mr Grantham's pick for such a drawnout collapse was based on assumptions of profit margins falling from 8% to 6%, and of sales per share growing at 3.6% annually. Such numbers would require the S&P 500 to deliver real returns of -0.5% annually over a decade.

Weaker profits haunt many companies and may continue going forward even if low interest rates stimulate economic recovery. Shares are not out of the woods yet. Even the New Zealand sharemarket, which has done so well during the global downturn, could be vulnerable to slippage now that some perceive it as difficult to find attractive value in for the very reason of its lift. A case could be made that the market has peaked.

Bonds should also be viewed with some suspicion. We are surely at or near the end of the interest rate easing cycle.

As interest rates rise, bond prices will fall. Bonds are possibly inflated in value currently due to flight-to-safety by nervous investors. The last time the Federal Reserve slashed US interest rates and then put them up again back in 1993, a bond crash followed. There was comment around that time concerning the irony of people remembering the 1987 crash but not even noticing the huge loss of value in bonds after rate rises in 1993.

The Japanese could have a lot of influence in a bond crash because they may need to repatriate assets as their economy crumbles. Another reason for selling off both bonds and stocks in the US could be worries by foreign investors that the greenback is overpriced.

The US currency has benefited from September 11 jitters but at least some foreign investors might be concerned that it has peaked and that they could face exchange rate losses ahead. To some extent higher US interest rates could support the greenback further out but a slump in the dollar or a hike in interest rates would hardly be a tonic for stocks and bonds.

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