Tim Cohen
6 July 2009
column
Johannesburg — WE HAVE reached the middle of the year and simultaneously, as seems appropriate, a pivot point in deciding what the near-term future of the markets will be. Markets are places of perpetual turmoil, and consequently almost perpetually in the grip of some or other mania.
However, even by the standards of market manias, the recent collapse and partial recovery is impressive. Now that the initial wave has washed over us, and we appear partially afloat although still bailing out water at a furious rate, we seem to have reached a new phase.
Most markets are more or less back to where they were at the start of the year.
With amazing global synchronicity, the S&P 500 is down 0,7%, the FTSE 100 is down 4,5%, FTSE Eurofirst 300 is up 1,3% and the JSE all share is down 2%. Asia is more positive, with the Nikkei 225 up 11,5% and the Shanghai composite up an extraordinary 68%.
Yet the sharp V shape of the trajectories is more or less the same, with the low point being in mid- March. It shows, as John Authers points out in his Financial Times column, The Long View, that panic has been followed by relief, and then by the nervous reassessment of the past two months.
One good example I read recently was a piece on Bloomberg, which noted that much of the international rebound had come from companies in real trouble.
In better times, we would describe these companies as value stocks. But given the global recession, these are highly indebted companies that are actually losing money like Ford.
Bloomberg drilled down a bit into which companies were creating the upswing, and discovered that money-losing companies with the most debt in MSCI world value index climbed an average 38% in the past quarter. This compares with a 20% improvement in the MSCI world value index.
To put it another way, what we have seen is a junk rally, and there are plenty of people who believe a junk rally is an incomplete foundation for a broader increase.
So is there any way of telling whether this recent increase is, in the colourful phraseology of traders, "dead-cat bounce" or not? One method mentioned by Authers is to look as something called the Tobin's Q.
The technique has a lot going for it. Price:earnings ratios are simple and often work, but in times like these they are simply haywire.
Tobin's Q, however, is rational, conceptually simple, was invented by a Nobel Prize winner, and has an excellent track record. One trader says it has identified every single generational buy opportunity.
Tobin's Q is simply the ratio of the current value of the market divided by the replacement value of those assets.
Why does that work? Simply because it creates a rational, nonvolatile comparative standard by which to judge the value of the market. Alternatives often involve comparing the market with itself.
One way to understand it is to think about a factory. What you are doing is comparing the market price of the factory with the cost of replacing it. Almost by definition, when this ratio is greater than one, the factory is overpriced by the market - and vice versa.
The idea gained some new adherents during the tech boom round about 2000 mainly as a method of finding an objective basis for cautioning about the boom, notably Andrew Smithers, who wrote a book called Valuing Wall Street; Smithers now runs an investment advice company based on the notion.
So how does Q actually work? One of the things Smithers points out in his website about Tobin's Q is that over the long term, the average value of Q is 0,63 or so.
This is because the replacement cost of company assets is overstated almost certainly due to the true economic rate of depreciation being underestimated.
Q data differ from price to book because Q is the ratio of price to net worth at replacement cost rather than the historic or book cost of companies. It's what it costs to replace now, not what it cost when it was actually bought.
The Q ratio for US equities has fluctuated between 0,3 and 3 in the past 130 years. The bad news is that Q data for countries other than the US is either nonexistent, or too short-term, or of poor quality, to be used to value the markets, Smithers argues. (He uses cyclically adjusted price:earnings (CAPE) for other markets.) Neither can it be used for individual companies.
But, given the convergence of global stock market movements, it still has relevance for SA.
The point is that Q data now are exactly on the long-term average at the moment, coming off a low of about 0,4.
This is one of those perplexing things that tells us a lot and very little at the same time. Since most recessions bottom out at 0,3 it could be bearish. On the other hand, it does not suggest markets are currently overvalued.
The problem is particularly acute in the short term.
Smithers asks himself the question: "If we can't use value to judge the short-term outlook, what can we use?" His answer is: "Probably nothing. If any technique was shown to be a good short-term predictor of the stock market, then it would be rapidly exploited and cease to work."
Yet, it remains interesting that for the long term the Q value is neutral now. This means that productivity must improve for stock markets to show substantial, real improvements from here.
With more and more countries improving their productivity dramatically, that's not as difficult as it seems. Yet fast improvements seem unlikely, and the wounds remain fresh.
The "show me" period has definitively begun.
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