Saturday, August 27, 2011

Stock market valuation in perspective...

A few days ago, I went to the brokerage firm to collect some data, I met a man about 20 years oldrt than myself with a folder full of documents. I overheard him telling the receptionist that he was there to open an online account and had brought documents to show his financial status so that he can get a good limit to buy stocks. He turned to me and asked me if I had an account with the brokerage and whether their system was any good. Having failed to get into the system a few times during the busiest times in the past few weeks of market panic, I told him that he might want to another account somewhere else in case that happens.  He then told me that he was going to buy stocks because he thought they had fallen far enough and was very cheap. I told him I was not too sure because the situation in Europe might get really nasty and cheap stuff can become cheaper. He wasn't worried...that the investors was worried about a recession but for him recession was nothing to be afraid of....his strategy of investing in dividend paying defensive stocks in large companies does have some merit. However, what was not clear to me was whether a recession is discounted already by the market falls.

I've seen analysts saying probability of a global recession is anything from 20 to 80% - my take is we are probably more likely than not to go into recession but how deep it is depends on what happens in Europe - is the situation is contained we may have slow growth or a mild recession....that is roughly the same. But has the stock market priced that in? ....

The graph above shows the price of stock relative to book value. Book value rough speaking is the amount of money that a holder of a common share would get if a company were to get liquidated i.e. stop its business and sell off all assets. If ever the stock price falls below the book value, value investors would consider it a real bargain and stocks are absolutely cheap because you can technically liquidate the company and get all your money back plus profits. Stocks have fallen below book value only twice in the last 25 years both times during a crisis - the Asian Crisis and Financial Crisis. During a garden variety recession stocks do fall but stay above the book value.

Using book value as a reference, the recent stock market fall has taken us roughly to valuation levels just after the 911 attacks in Sep 2001 - remember the post-dot com bubble recession? It was a slow drop for stocks that took about a year as stocks slowly but steadily drop as the economy slowed towards a recession - then the 911 attack suddenly came people were already expecting a recession. There was a post-911 bounce when the US Fed cut interest rate aggressively but SARS cam and took further below the post-911 low.

The stock market right now discounts a mild recession and definitely discounts a slowdown in the global economy. However, it does not discount some kind of crisis like SARS or a financial crisis.

The big question now is whether the European debt situation can be contained and stabilised....and put into some kind of graceful degradation to spread the pain over time. Speculators attacking the stocks of  European banks attempt to precipitate a crisis and we know from past crisis that they can succeed  bringing down the European banking system and put the European economy into a deeper recession than necessary. In an earlier article, I explained that large amount of Greek and Italian debt held by German and French banks links the sovereign debt crisis to the European banking system . I'm not optimistic that the worst case will not happen especially after seeing the disunity among European leaders. Having said that the ESFS[Link] is probably sufficient to buy some more time provided the govts step in to aid the banks (read Why European Banks are Stressed out? and Faith in European Banks Fraying). They might not because it is politically unpopular[Investors Fret at costs if rescues are needed] and Ireland got itself into a mess because the govt's rescue of the banking system sank the country into deeper debt. If they want to do something about the banks, they will have to do it soon otherwise it will become too expensive and too intractable. Something like Buffett's US$5B injection into Bank of America [Buffett Pockets $1B in BoA 'rescue']can do wonders to restore confidence.  If nothing is done soon, this crisis will run its full course....and you may get the chance to buy stocks below book value just like during the Asian Crisis and the Fincnial Crisis. [Here is an excellent paper explaining in full the situation in Europe and possible outcomes :  Europe on the Brink]


Anonymous said...

The famous things about analysts are

Analysts are wrong most of the time.
Analysts are good in explaining what had happened; these are events any ordinary person with common sense definitely knows how to see and interpret for himself.
Analysts are bad in forecasting what is going to happen.

Don't need to waste money, time and energy to watch, hear and read from analyst.
Put it simply: Analysts are wasting in eating all the rices.

Can analysts do one and only one favour for this world?
Analysts, please vomit out what you had eaten all these years.

truth be told said...

An old saying that one cannot time the market.

In a bull market or bear market, there will always be two opportunities to enter or exit the market.

these 2 points will only be realised after the fact, after plotting the charts.

The "low" prices on some stocks may go even lower, but at some point it will make a U turn and move up. This presents another opportunity to buy or sell depdending on the purpose.

The bigger question of: will the world economy go into some slow and painfull death? Who knows?

Regardless if its yes or no or maybe, it will not happen in my lifetime.. ( the next 30 years )

Money as we know it will continue.
Trade as we know it will continue
Work as we know it will continue
Life as we know it will continue

We are told again and again how each of us, each country is interconnected, that isolation or insulation is impossible.

That being the case, I will still invest into the stock market, buy SMRT, SINGTEL, SIA and KEPcorp... even if Tan Jee Say is president...
they are not going to belly up and close shop.

Will their share price go lower?
Maybe. Should we buy more then?
There lies the next question:

Do you have cash to buy?

No worries, theres plenty of that all over the place at very, very cheap rates.

If 'many people' ( to borrow a famous term ) are buying gold... how are they paying for it? cash I suppose.. then who is holding this cash now? How are they deploying it? keep it under the mattress?

Until my fishmonger insists I pay in gold or some other means, my $50 note will be used.

There will always be a market
There will always be a buyer.

Its all about price.

since man came into being, there has always been a price.

tempest said...

Dear Lucky,

Please forgive me for pointing out that the European facility is acronym-ed as EFSF, rather than "ESFS".

An angle which is seldom mentioned pertains to the potential fall-out from the European sovereign debt issues. What is commonly known is that the economies of periphery Euro nations are screeching to a halt. European banks holding sovereign bonds potentially face hair-cuts on their holdings, which leaves the impression to many that the situation there would possibly be contained.

What that is seldom mentioned, as we find out from BIS through here (, US banks have massive exposure to European sovereign debts through derivatives known as Credit Default Swaps (CDS), the same instrument that dealt AIG a mortal blow during the last crisis in America. Simplified, CDS transfers the risk of default to the instrument issuer. For example, SocGen owns $10B of Ireland bonds. They turn around and buy $10B worth of CDS from JP Morgan on the other side of the Atlantic. If Ireland defaults, the mentioned CDS triggers and JPM has to pay out the bond value to SocGen. Although SocGen is the holder of the bond, it has transferred the risk totally to JPM with the purchase of a CDS.

The CDS market is unregulated as far as we know, so we don't really know the exposure of the American banks or any other major banks for that matter. When you have a default from an European nation in the future, we won't know for sure who will be left carrying the bag, hence the global sell-off in most banking stocks.

So far, we have been talking about LONG CDS, which is a derivative of an underlying bond, may it be sovereign or corporate. In theory, we should have 1 CDS to 1 underlying bond. But that's not all. A long CDS means a holder has an underlying bond to protect with that derivative purchase.

There is also in existence, short CDS holders. Speculators purchase CDS without owning the underlying bonds to profit in event of a default. Short CDS profits only when the bond issuer defaults, which means they have an incentive to push in that direction. One can see where this leads to. Naked CDS holders, theoretically, can hold derivative value many times that of the actual bond issued. The speculator can buy 5 CDS without owning a single bond to leverage 5times. There is absolutely no visibility on how much CDS is floating around in the derivatives market. I've read an article before that postulated Goldman Sachs has 1 trillion in derivative exposure. You throw in counterparty risks and exposure, the whole financial system sinks into the toilet simply with the implosion of GS. Its all a big fat blackhole with the interconnection of major financial institutions today.

This note is getting too long but I would recommend a read of Andrew Ross Sorkin's 'Too Big To Fail'. It is written like a fiction except the events actually happened. Definitely worth the time, page turner and I couldn't put it down until the last page.

Anonymous said...

Credit Default swaps and other types of instruments being tossed around by financial entities are their own creation for their own goals.

Ordinary people like me are not aware of the nature, purpose and risks of these tools. Very much like you and I are not aware of the different types of concrete mixtures and labour costs to construct a road or building.

Yes, they are not regulated unlike the building industry. But why should I care? Do I have confidence in buying Far East Organisation's homes or Tunnels built under the LTA's tender excercise?

Do I have a choice, a say in the matter?

I say: if the boat sinks.. all will go asunder.

Anonymous said...

The vast majority of U.S. workers, however devoted and skilled at their jobs, have missed out on the windfalls of this winner-take-most economy—or worse, found their savings, employers, or professions ravaged by the same forces that have enriched the plutocratic elite. The result of these divergent trends is a jaw-dropping surge in U.S. income inequality. According to the economists Emmanuel Saez of Berkeley and Thomas Piketty of the Paris School of Economics, between 2002 and 2007, 65 percent of all income growth in the United States went to the top 1 percent of the population. The financial crisis interrupted this trend temporarily, as incomes for the top 1 percent fell more than those of the rest of the population in 2008. But recent evidence suggests that, in the wake of the crisis, incomes at the summit are rebounding more quickly than those below. One example: after a down year in 2008, the top 25 hedge-fund managers were paid, on average, more than $1 billion each in 2009, quickly eclipsing the record they had set in pre-recession 2007.
Think it is only happening in the west, think again, think lehman....
Financial weapons of mass destruction is being used against everyone whatever race colour or creed.

Anonymous said...

"Stocks have fallen below book value only twice in the last 25 years both times during a crisis - the Asian Crisis and Financial Crisis."
Lucky Tan

I agree with you. That was during 1997/1998 and 2008/2009.

Those who bought at those times will make a fortune(just a matter of big or small) anytime.

So going by the past intervals, the next one may not be so soon again.

Maybe in 10 years time?

In the mean time, work hard, work smart and also save hard for your money.

Don't expect luck or blame PAP govt if you can't.

Anonymous said...

By this post at this time, and the length you wrote about possible recession show that:
1) you heck care about presidential election, and
2) you have more fear than greed


Anonymous said...

Analytics are nice and bombastic, but they are nothing more. Nonsense shared in high society are always sweet to the undiscerning. Long term capital is proof. If you really insists that history does repeats itself through the footprints it leaves, then any lagging, idiotic technical indicators would do better than those anal-analysis nonsense sprouting goons.

hyom said...

Hi Lucky Tan,

I have always looked forward to read your market commentary. Even if the world is headed for double-dip recession, I am confident that will at least be one more strong rally in the Singapore market before the market collapses.

There is plenty of cash sitting on the sidelines and big foreign fund inflow as can be seen from the negative swap offer rates. There is so much cash hanging around that the Bank of New York Mellon is charging fees on big deposits instead of paying interest.

There are plenty of insider buying announcements on SGX lately. Same thing for the US markets where the CEOs are buying back heavily.

On valuation, I think those who keep stocks on their watchlist will be adding more to their watchlist recently. Valuation are still good at this point. Profits in the recent quarter have actually improved among the S&P 500 companies.

Anonymous said...

.. another bloomberg ANALysis!

Lucky Tan said...


CDS again as the transmission mechanism?

I thought the US bank exposure to European side was negligible and the US banks were falling due to the US housing market becoming cheaper, the flattening of the yield curve that hits their earnings and weak US economy.

I remember reading a few reports and something from Geithner who said that the exposure is very small. I'm surprise...really surprise if that is not the case...why would Buffett put $5B into BoA with the CDS toxic poision in US banking system...somebody must know something! said...

Oh my god, there's so much helpful info here!

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