The year 2003 was quite frustrating for the bears and value investors alike. Almost all financial assets went up, be they bonds or equities, whether in emerging markets, the United States, Europe or even Japan.
In fact the riskier the asset the higher the return, with emerging market equities and bonds leading the pack followed by junk bonds and junk companies (stocks with price below $1).
The reflation trade was on in full measure with beta being the defining characteristic determining out-performance. Commodities as an asset class also had a great year.
The only asset class to actually decline was the US dollar, driven more by the sustainability of its financial imbalances.
As we move deeper into 2004, the markets are already beginning to move into a more fundamental mode and investors are beginning to question valuations once again (at last).
Technology as a sector is beginning to fade and the top 12 tech names in the US have seen their combined market capitalisation stall at $1.2 trillion for the last 6 months despite the markets being up over 10 per cent in this period.
As markets hopefully focus more on fundamentals the first question as always will be " how cheap are the markets?". Ultimately valuations at entry (when making an investment)are the most important determinant of long-term returns.
I plan to focus in this essay on the US, as it remains the driver of global markets, but broadly similar conclusions can be arrived at for most developed markets.
If you listen to Warren Buffett and many other of the more seasoned investors, they are quite emphatic that in no way can Wall Street be called cheap.
Buffett in his latest missive opines "We've found it hard to find significantly undervalued stocks. The shortage of attractively-priced stocks in which we can put large sums doesn't bother us. Our capital is underutilised now, but that will happen periodically. It's a painful condition to be in but not as painful as doing something stupid."
So the great man has very clearly spoken. He obviously thinks the US market is over valued, but what do the valuation metrics look like? Is the case that clear cut?
To answer this question I have always found the work of Dresdner interesting in this regard. They use valuation metrics which attempt to strip out the business cycle but at the same time are not exotic equations but simple P/E's.
They use three such measures, the Graham and Dodd PE (prices are compared to a ten-year moving average of earnings), the Hussman PE (where prices are compared to peak cycle earnings) and a trend PE (where prices are compared to trend earnings plotted since 1955).
I find these valuation measures to be far more robust and useful in cutting out a lot of the noise associated with tracking the US markets and its quarterly results phobia. They also force one to take a truly long-term view of the markets, valuation history and are more stable over time.
If you look at the current levels of these three PE's and their long-term averages, the message is very clear, the US markets are very expensive relative to their own history.
The Graham and Dodd PE has a current reading of 30 versus its long-term average (LTA)of 17.6, the Hussman PE has a current reading of 20.6 versus an LTA of 11.7 and the Trend PE has a reading of 23 now versus an LTA of 16.
Of course most investors do not tend to use these type of longer term measures and find solace in using PE multiples of one year forward (pro-forma) earnings.
No matter all the issues with using pro-forma numbers (not audited, no uniformity), even on this metric the market is not cheap. The current 12 m forward PE based on consensus numbers is 18. The average since 1985 is around 15,being closer to 13 if you strip out the bubble years.
One can only use this metric for comparison purposes since 1985 as there was no formal collation of one year forward consensus earnings numbers by anyone before this date.
However Dresdner -- using some assumptions -- has attempted to recreate a one year forward PE multiple series since 1955 and arrives at a long-term average of 12 for this metric. Comparing this long-term average to the current 18, it again indicates significant overvaluation.
The bulls always tend to fall back on the defence of valuations being cheap compared to interest rates. Some variant of the Fed model is used and will show equities as being cheap compared to the current low bond yields.
The problem with this in my view is that being a relative valuation tool you run the risk of the model showing you that bonds are very expensive as opposed to equities being cheap.
It is similar to how in the Internet bubble anything looked cheap compared to say an Amazon or Yahoo, and this relative comparison was used to justify the valuations of a whole bunch of dodgy Internet start ups.
People only realised later that everything else looked cheap because of the absurd valuation levels reached by these two Internet icons.
The low interest rate argument also suffers from what Dresdner calls money illusion. Equity prices should equal the net present value of all future cash flows, and the market is an aggregation of all the individual companies.
These future cash flows are largely indexed to inflation, 75 per cent of the earnings growth achieved since 1950 has been the result of inflation. If nominal bond yields are low it is likely due to reduced inflation expectations.
These reduced expectations equally impact the prospects of future cash flow growth for equities. What is gained from a lower discount rate will be lost from a lower cash flow growth profile. Hence the net effect on equities of very low bond yields should be minimal.
The other problem with low interest rates is that you risk PE contraction over time, which will significantly lower long-term equity returns.
Your best chance of multiple expansion is actually when current interest rates are high not low. Low interest rates may explain why current PE's are high (money illusion) but they say nothing about future sustainability of these PE's.
Thus whichever way you look at it, using more stable longer term valuation measures, it seems difficult to call the US equity market cheap. Momentum aside the fundamental valuation support for this market looks weak.
In my book at least, the current low interest rates cannot be used as an excuse to justify valuations. Investors are probably well served to heed Mr Buffet's advice and not feel compelled to invest simply because they have cash.
Having the discipline to keep cash lying idle until a truly attractive investment opportunity arises is probably one of the most difficult things for an investor to do.
Human nature compels us to always want to be in the middle of the action. This ability to resist is what sets apart good investors from the mediocre.