Why fairly valued stock markets are an opportunity
By Martin Wolf
We have bad news and good news. The bad news is that the world economy is teetering on the brink of what may well be the most damaging slowdown since the second world war. Policymakers around the world – particularly in the inordinately complacent surplus countries – do not begin to understand what this may mean. The good news is that, after an extended period of overvaluation, stock markets are, at last, attractively priced. This should have enticing implications for investors and even for audacious governments.
How does one measure fundamental value? The chart shows two such measures – “Q” and the “cyclically adjusted price earnings ratio” (Cape).
The first of these measures derives from the work of the late James Tobin, a Nobel laureate economist. Q is the ratio of the value of an individual stock (or of the stock market as a whole) to net assets, at replacement cost. Tobin initially proposed this ratio as a way of explaining investment. Andrew Smithers of London-based Smithers & Co, from whom I have obtained the data, realised that Q could be turned round, to value the stock market, instead: high Q then forecasts not so much an investment surge as a stock market fall, and vice versa. If the stock market values the net worth of a company at far more than it costs to re-create its assets, either assets should expand or the market valuation should fall. In practice, argues Mr Smithers, it is more likely that the market is wrong than the investment decisions of companies.
The second of these measures has been used, in particular, by Robert Shiller of Yale University. The denominator is a 10-year moving average of earnings, in real terms. The purpose of this adjustment is to eliminate the cyclical effects on earnings that make price/earnings ratios look low at cyclical peaks, when earnings exceed sustainable levels. At times of rapidly increasing leverage, such as the 2000s, cyclically unadjusted earnings are likely to prove particularly meaningless because they are intensely vulnerable to changes in economic conditions. Leverage, after all, works both ways.
These two indicators should, if properly measured, give much the same result. The chart, which measures Q and Cape, relative to their long-run averages for the US, shows that they do.
What, then, does it show? I would focus on five principal conclusions.
First, valuations show pronounced long-term cycles. They are not a “random walk”. But these cycles are so long that it is nigh on impossible for investors to bet successfully against them: they will run out of money before momentum-driven markets change their mind. This is why markets may be inefficient and yet private investors cannot easily make money betting against them.
Second, the market has seen three peaks since 1920: 1929, 1965 and, biggest of all, 1999 (on the Cape). Prolonged bear markets followed in all cases. Peaks were, in other words, bad times to “buy and hold” – the recommended strategy in the 1990s.
Third, the market has also seen two bear market troughs since 1920: 1932 and 1981. These were excellent times to buy stocks. It helps if purchasers are patient: the period from trough to subsequent peak was 33 years and 18 years, respectively.
Fourth, the US stock market has been in a bear market since 2000, with two downward legs, 2000-2002 and 2007 until now. In the first leg, corporate investment remained weak, as stock prices collapsed. In the second leg, the credit and housing bubbles – partly explained by the Federal Reserve’s response to that investment weakness – imploded. This story is normal: bear markets usually coincide with periods of recession (see chart).
Finally, today’s valuations are considerably below average for the first time since 1988, on the Cape, and 1991, on Q. This does not mean they could not fall far further and, in bad conditions, they are even likely to do so. But, unless one expects another Great Depression and world war, history suggests valuations should not remain below current levels for more than, say, 15 years or so. That may not sound very enticing. But it is a different story from what people like Prof Shiller and Mr Smithers argued back in 1999, when history suggested one might never see such valuations again. Rational people would buy now, not then. Rational people, alas, are rare. As Warren Buffett has argued, buy when “Mr Market” is scared, not when he is bold.
The average valuation of the US stock market corresponds to a real return of 6½-7 per cent, which implies an “equity risk premium” – a margin of return over risk-free government bonds – of about 4 percentage points. This has long seemed high. During the great bull market of the 1990s, some even argued that no such premium was justified. But if one has to ask why equity holders should be risk-averse, one need only look at history. For mortals (rather than immortal institutions), the risk of being caught in a bear market (that is, a period of below average valuations) for 15 years, as happened from 1973 to 1988, is scary. Anybody retiring today knows this.
Directly comparable data are unavailable for other markets. But data on ratios of stock market valuation to gross domestic product for the world, the European Union and the UK, since 1980, have a similar pattern to those of the US. Correlation across markets is so close that what applies to the US should apply to the rest. Japan is different, however. The valuation peak there was in 1990.
I draw four implications. The first is that investors with long time horizons (the relatively young, or institutions) are, for the first time in almost two decades, confronting attractive, although not sensationally attractive, market valuations. The second is that there are, nevertheless, formidable pressures for further falls in valuations, as leveraged players continue to be forced to offload assets at bargain prices. The third is that bottom-fishing investors may at last start to supply some of the equity capital that companies – particularly financial companies – need, once a floor on asset prices is at last set.
Finally, governments might sensibly act as stabilising speculators, as John Muellbauer of Oxford university and Michael Spence, the Nobel laureate from Stanford University, suggested in Tuesday’s Financial Times and on the Economists’ Forum, respectively. Governments have the deep pockets and the time horizon that is needed. They can offload what they buy when markets have recovered. To the extent that the collapse of markets is self-feeding, such actions should also stabilise the economy. Given the unprecedented actions taken in recent months, this no longer seems a policy step too far.
India's Prime Minister Manmohan Singh: "Whatever measures are necessary"
India's Prime Minister Manmohan Singh has vowed to take "whatever measures are necessary" to track down those responsible for the Mumbai attacks.
He said the perpetrators were based "outside the country" and India would not tolerate "neighbours" who provide a haven to militants targeting it.
Gunmen targeted at least seven sites in Mumbai late on Wednesday, killing at least 101 people and injuring 300.
Flames were seen rising from the roof of one hotel where people were trapped.
Elite commandos had begun an operation to free hostages at the hotel, the Oberoi-Trident, where dozens of people are said to remain trapped or held hostage, reports said.
A home ministry official said between 20 and 30 people at the hotel might still be hostages, while the owners said some 200 people were trapped inside.
Police earlier said hostages had been freed from another luxury hotel, the Taj Mahal Palace, but explosions and gunfire were still being heard by witnesses outside.
A stand-off continues at a Jewish centre, where an Israeli rabbi and his family are believed to have been taken hostage.
One militant reportedly phoned local TV from the centre offering to negotiate over the release of hostages.
In other developments:
- The Indian navy said it was searching ships off the west coast following reports that gunmen had arrived in Mumbai by boat
- The UK Foreign Office said a British national had died; a German, a Japanese man and an Italian are also among the dead
- The Pakistan-based militant group Lashkar-e-Toiba, which has been blamed for past bombings in India, denied any role in the attacks
In a televised address, Mr Singh said the government "will take whatever measures are necessary to ensure the safety and security of our citizens".
He described the attacks as "well-planned and well-orchestrated... intended to create a sense of panic by choosing high profile targets and indiscriminately killing foreigners".
 | MUMBAI ATTACKS   |
The perpetrators were "based outside the country", he said, adding that they "had come with single-minded determination to create havoc in the commercial capital of the country".
India has complained in the past that attacks on its soil have been carried out by groups based in Pakistan, although relations between the two countries have improved in recent years and Pakistani leaders were swift to condemn the latest attacks.
Pakistani Foreign Minister Shah Mahmood Qureshi, in New Delhi for talks, said no-one should be blamed until investigations were finished.
"Our experience in the past tells us that we should not jump to conclusions," he told Dawn television.
Amid international condemnation of the attacks, US President George W Bush telephoned Mr Singh to offer his condolences and support.
Claim of responsibility
In the attacks late on Wednesday night gunmen, using grenades and automatic weapons, targeted at least seven sites including the city's main commuter train station, a hospital and a restaurant popular with tourists.
Police say 14 police officers, 81 Indian nationals and six foreigners have been killed.
Four suspected terrorists have also been killed and nine arrested, they add.
State police chief AN Roy earlier told local television that hostages held by the gunmen at the Taj Mahal Palace hotel - one of Mumbai's most famous hotels - had been freed.
People escaping from the Taj Mahal Palace hotel
Witnesses said civilians could be seen running from the hotel, some with suitcases. Ambulances were also reported to be arriving.
But the BBC's Mark Dummett, outside the Taj Mahal, says the situation has since become very confused, with the sounds of explosions and gunfire being heard from within the hotel, suggesting the siege is not yet over.
Earlier in the day, Indian commandos had been seen entering the hotels but there was little detail on the operation.
Meanwhile, the bosses of the Oberoi-Trident hotel say some 200 guests may still trapped in their rooms.
Earlier eyewitness reports from the hotels suggested the attackers were singling out British and American passport holders.
If the reports are true, our security correspondent Frank Gardner says it implies an Islamist motive - attacks inspired or co-ordinated by al-Qaeda.
A claim of responsibility has been made by a previously unknown group calling itself the Deccan Mujahideen. Our correspondent says it could be a hoax or assumed name for another group.
Terrorist attacks in Mumbai
India under attack
A terrorist attack in Mumbai kills at least 100 people
THE sheer scale and audacity of the assault were staggering. Gangs of well-armed youths attacked two luxury hotels, a restaurant, a railway station and at least one hospital. Gunfire and explosions rang through Mumbai overnight on November 26th-27th and through the next morning. By Thursday November 27th more than 100 people were reported to have been killed, and the toll seemed likely to rise. Several foreigners, including some from America, Japan and Britain, were among the dead. So were over a dozen policemen, including Mumbai’s chief counter-terrorism officer. Up to 100 hostages, including selected American and British guests, were alleged to be held hostage inside a hotel.
Even in a city—and country—with a grim record of terrorist violence, these were extraordinary scenes. The attacks started at around 10.30pm on Wednesday, when gunmen started shooting and throwing grenades at Mumbai’s main Chhatrapati Shivaji Terminus railway station. Television footage showed two men shooting at random as they drove through nearby streets in a stolen police jeep.
Around the same time, a bomb was reported to have exploded in a taxi parked near the city’s main airport. More or less simultaneously, gunmen speaking Hindi and Urdu, the language of many north-Indian Muslims and of neighbouring Pakistan, stormed two hotels—the Taj Mahal and the Trident Oberoi—and Café Leopold, a restaurant popular with tourists. Police outside the Taj Mahal, India’s most famous hotel, lapped by the Arabian Sea, said gunmen arrived there by inflatable dinghy. In the early hours, a gunfight erupted on Marine Drive, the scenic coastal road seen in so many Bollywood films, in which another Mumbai police chief was killed.
As dawn broke, flames were rising from the domed roof of the Taj Mahal. Navy and army commandos, who had retaken the hotel’s lower floors and killed two terrorists, reported bodies in many rooms and perhaps half a dozen terrorists still living. A trickle of terrified employees and guests, some with gunshot wounds, continued to flee the building. One fugitive, Amit, a hotel-restaurant manager, said his chef had been hit by three bullets and many colleagues remained inside. A few badly-injured survivors were wheeled from the hotel on brass luggage-trolleys. By midday on Thursday most of the hostages were reported to have been released from the hotel, although there were reports of further shooting.
Meanwhile at the nearby Trident Oberoi, as many as 100 hostages were reported still to be held. Gunfire and explosions were reported from the upper storeys of the building.
There seemed little doubt that the attackers were Muslim militants of some description, but their exact provenance was unclear. Responsibility was claimed by a previously little-known group called the Deccan Mujahideen. Speaking to Indian television by telephone, a gunman holding hostages in the Trident Oberoi demanded that Muslim prisoners, including those captured in Kashmir, should be released from Indian jails. “Release all the mujahideens, and Muslims living in India should not be troubled,” he said.
In the past five months India has suffered from a spate of Islamist militancy, with bomb-blasts in half a dozen cities, including Delhi, Bangalore and Jaipur. A home-grown Muslim terrorist group, the Indian Mujahideen, has been blamed for the spree, in which over 150 people were killed. In a chilling, 14-page admission of responsibility for the Delhi bombings in September, the Indian Mujahideen castigated the counter-terrorism efforts of Mumbai’s police, and promised Mumbaikars future “deadly attacks”.
As India’s first indigenous Muslim terrorist group—so they have often been described—the Indian Mujahideen are a worrying sign. They seem to have evolved from a decade-long campaign by Pakistan-based militants, including many fighting an insurgency in Kashmir, to incite India’s 140m Muslims to revolt. These groups have been held primarily responsible for half a dozen major terrorist attacks in Mumbai in recent years. In 1993 local Muslim gangsters backed by Pakistan-based militants set off 13 near-simultaneous bomb-blasts in the city, killing more than 250 people. In 2006 another co-ordinated bombing spree on Mumbai’s railway killed over 180 commuters. A Pakistan-based group, Lashkar-e-toiba, was blamed at the time.
This week’s attacks in Mumbai seemed different, however. Attacks by bands of gunmen on numerous targets, instead of the mere laying of bombs, and the seizure of so many hostages, led to speculation, unsupported by evidence, that local militants in India could not have mounted the attacks without considerable foreign help. And the targets chosen—world famous hotels and Western tourists—was a new phenomenon for India, despite being a pattern familiar from attacks directed or inspired by al-Qaeda elsewhere in the world.
Al-Qaeda has often threatened to launch strikes on India. In 2006 Arab terrorists belonging to the organisation were foiled in an attempt to set off bombs in Goa, India’s main destination for foreign tourists. Among the targets of the latest attacks was a Jewish religious centre in southern Mumbai which was reported to have been attacked by the gunmen. Police said that an Israeli rabbi and his family were among a group being held as hostages in a nearby apartment block.
Despite these worrying signs, Indian officials have so far resisted suggestions that Indian Muslims are being radicalised and joining a global jihad. Many refer approvingly to the observation of George Bush that Muslims from India have not in general turned up to fight the infidels on the battlefields of Iraq and Afghanistan. But security analysts have meanwhile despaired at the unpreparedness of India’s security agencies to counter a domestic Islamist threat. Whether or not al-Qaeda was behind the latest attack, that happy complacency must now have ended.
Nov. 27 (Bloomberg) -- Deflation is destined to make an untimely return to Japan.
The second-biggest economy faces the most acute threat of falling prices among industrialized nations, the Organization for Economic Cooperation and Development said on Nov. 25. Sound gloomy? The OECD may be overly optimistic to think deflation won’t reemerge until the second half of 2009.
Things aren’t as dire as they seem. In fact, a return of deflation may offer benefits to Japan’s outlook. That also could go for other developed nations experiencing mild price drops. Japan’s latest inflation figures will be released tomorrow.
Deflation was the unheralded catalyst behind the restructuring that fueled Japan’s longest postwar recovery. Officials in Tokyo have been quick to blame the U.S. credit crisis for Japan’s recession. An explanation that deserves equal weight is that the positive side effects of deflation didn’t have enough time to assert themselves.
To make such an argument is to delve into the territory of economic heresy. It’s true that falling prices are rarely, if ever, good for the broader economy. They are a nightmare for debt holders and property owners. They can hurt corporate profits, cut wages and eat into government tax revenue.
Yet Japan benefited from deflation in two ways. First, it offered a kind of stealth tax cut for consumers, who gained more purchasing power between the late 1990s and mid 2000s. Second, it forced major change in the bloated, inefficient economy.
Deflation’s Benefits
China’s rise was among the forces that prompted Japanese executives once and for all to restructure. Companies streamlined a labyrinthine distribution system that involved many middlemen and inflated prices. Banks also realized in the early 2000s that they couldn’t grow their way to health. They stepped up efforts to dispose of bad loans.
There’s a reason, though, why Japan’s political and corporate establishments were so frightened by deflation and obsessed about ending it. It was an uncertain and destabilizing force they couldn’t control or understand.
Policy makers wasted several years acting as if deflation was the cause, not a symptom, of Japan’s malaise. It was more about a malfunctioning credit system and increased global competitiveness. Whether officials know it or not, Japan’s growth in recent years owes much to deflation.
Inflation’s Return
The return of inflation, albeit mild price increases, in recent years prompted the popping of champagne corks from Tokyo to Washington. It also took pressure off the government to continue efforts to modernize the economy.
As deflation threatens to make a comeback, officials in Japan and elsewhere need not panic. The key is to keep the trend modest. Aggressive drops in consumer prices won’t help business or investment confidence. And they certainly wouldn’t bode well for stock markets.
Like it or not, falling prices are something with which governments around the globe will need to grapple. Hungary, Iceland, Ireland, Spain and Turkey will experience “severe” economic declines, many because of housing slumps that “still have a long way to go,” the OECD said. It added that deflation has become a greater risk than inflation.
Deflation in China is certainly a threat if the global crisis gets worse. In Japan, Taro Aso certainly won’t appreciate being remembered as the prime minister who oversaw the return of deflation. And yet he’s taking very doctrinaire steps to stabilize growth, like fiscal pump priming.
Changing World
Lacking in Tokyo these past couple of years has been long- term planning to prepare for an aging population and boost entrepreneurship. The Bank of Japan also is reluctant to take more drastic steps to fight deflation -- such as returning interest rates to zero from today’s 0.3 percent.
The world is changing faster than Japan’s policy makers can adjust. The return of deflation will make it harder to remove structural impediments to growth with lax monetary and fiscal policies or a weak currency. Such measures offer short-term gains at the expense of long-term prosperity.
The good news is that Japan’s deflation didn’t turn into the global nightmare the U.S. feared. In October 2002, for example, Nikkei English News reported that the Central Intelligence Agency was investigating the effects of Japan’s deflation.
It had all the makings of a Tom Clancy novel and showed just how concerned the U.S. was about the dynamic hurting American consumers. Now, of course, economists are left wondering if the U.S. is headed toward deflation.
Japan is the more immediate risk. The BOJ didn’t formally end its deflation-fighting policy of pumping extra cash into the economy until March 2006. It’s worth noting that it took record increases in oil and food prices to produce a bit of inflation.
Now, “there is a high probability that Japan’s economy will slip into deflation in the third quarter of 2009” as core consumer prices turn negative, says Kyohei Morita, chief economist at Barclays Capital in Tokyo.
It could happen sooner if the global outlook turns even gloomier in the months ahead. While not good news for Japan’s leaders, history shows that may not be the disaster it seems.
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