Tuesday, 18 November 2008

Cheap shares? Don’t hold your breath

Turn on the business TV and you will find out that according to the experts there, shares worldwide are now cheap. One of the things I have noted, is that the enthusiasm for saying that stocks are attractive appears to be inversely proportional to the age of the expert (OK, Warren Buffett is the exception). I suspect the reason more seasoned observers have some problems digging out the enthusiasm is that "this time it is different".

Remember that catchphrase? It was very popular during the internet boom and summarised the pie-in-the-sky arguments why stocks should continue to increase even if valuations were already off the scale. It of course appeared that things were not different. The stock market proved not to be able to walk on air forever.

This time around I believe the use of the TTID is far more justified. We are not just talking about a normal downturn here. We are talking about what increasingly look like deepest and widest economic setback since the '30s. But we are not only looking at a situation where company earnings are falling as the result of a normal economic recession. We are looking at a situation where a lot of the rules are being rewritten and at this moment in time nobody really knows what the outcome will be.

One thing is certain; the financial sector will come out of this crisis with a dramatically reduced scope for actions and with a significantly reduced profitability. Everybody with some insight into the matters has understood that one of the drivers of the folly in the banking sector has been securitisation. Banks have been able to arrange for credits without having to take the risk on their own balance for very long. This disintermediation will in all likelihood be reversed.

Issuance of lowly rated corporate bonds will be significantly reduced because the borrowers will be critical and the rating agencies will be forced to clean up their act, much like the audit companies after the Enron scandal. The banks will thus have to carry more risk, the risk will be controlled far more precisely and the banks' earnings will come down because the underwriting fees will shrink. Add that the banks will be forced to come clear about derivative products created on the basis of the corporate loans (CDS's and CLO's). If the junk bond debacle in the late '80 is anything to go by, it will be at least 10 years before the CDO's and CDS's will again become mainstream. For a while such products will be vilified and regulators will come down hard on financial institutions if they try to get too massively back into that business.

This will in its turn make life much harder for private equity companies, venture capitalists and leveraged buy-out artists as the effect will be to make credit more scarce and more expensive. Over the past 3-4 years many bankers have privately shaken their head at the fact that risk was priced so aggressively. No more so, and we are likely to go to the other extreme for quite a while.

At the end of the day, the changes in the financial sector will end up making it more difficult to continue with the restructuring trend that has been at the root of the increased profitability of many companies. A combination of increased risk aversion, more expensive credit and tighter regulation is a bad cocktail for a return to the quite intensive M&A activities of the past years. This will in itself act as a brake on the future development of profitability.

But it is getting worse. According to a report titled " Preparing for a Slump in Earnings " from McKinsey, between 2004 and 2007, the earnings of S&P 500 companies as a proportion of GDP expanded to around 6 percent, compared with a long-run average of around 3 percent, with the highest increase in the financial and energy sectors.

This growth in earnings was primarily driven by increased sales. According to McKinsey, expansion of margins was not a significant contributor to overall earnings growth. These revenues were fuelled by the expansion of consumer credit. Now take a look at the collapsing property prices, the trouble in the US credit card companies, the fact that despite massive government subsidies, banks are tightening credit standards. Worldwide – and most so in the US – households will be led into a deleveraging of their own balance sheets. That will – as I have repeated before – lead to a period of sub-par growth in demand.

Then there is the banking sector itself. Using US data, we get the extremes of a story that can be told in every western country: from being 7.5% of the S%P 500 in 1990 it rose to a whopping 22.3 per cent in 2006 and currently it is still the biggest sector, standing at 16.0 per cent. This development is of course the immediate result of the strong increase in profitability of the banking sector. Not bad for a sector that in fact creates no value in the form of GDP except for the salaries to the employed. With the changes under way that will lead to lower profitability, it is difficult to see how finance stocks can lead the stock markets upwards.

There are probably those who are significantly better than I when it comes to crystal ball reading. I just observe that a host of parameters influencing the stock market valuation are in a state of flux. Calling a bottom in the stock market under these conditions appear rather ambitious.


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