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OPDU Report 25
- November 2008 Colbert, Louis XIV’s finance minister, once famously described the art of taxation as that of: No doubt Hank Poulson would agree that obtaining money for the bailout of the US financial sector falls into pretty much the same category, although his plucking operation was preceded by a lot of ruffled feathers. There has certainly been a great deal of hissing to date. Whether the package will be sufficient to provide the stability that the markets so craves remains to be seen, but the substantial action taken by monetary authorities, central banks and governments around the world bears testament to the depth and seriousness of the situation. The problem, in essence, The irony of the play is, of course, that Iago does not deserve his good name. He has, in fact, been up to no good, and the result is tragedy, as the consequences of his actions unfold. It is interesting to note that only a short while ago the retail banking network of Wachovia Bank was being sold to Citicorp for the sum of $2.16 billion, with considerable assistance from the Federal Deposit Insurance Corporation, and then a subsequent bid was received from Wells Fargo Bank for the whole of Wachovia’s operations for $15 billion,requiring no reliance on the taxpayer. Although rather different deals, it In such uncertain times, when the volatility of share prices is so large in the short term, it must clearly be a pre-eminent priority for investors to have some idea of whether there is any available benchmark against which they can judge share prices to provide some measure of value. This is particularly the case for pension funds where there are regular contributions coming in to be invested, For those who believe that markets are random, and that today’s price is no guide to that of tomorrow or of the day after, there is little hope for such a benchmark However, Smithers & Co does not believe that markets are random. The research of Smithers, based on Tobin’s ‘q’ (the value, adjusted for inflation, of corporate net worth) and that of Professor Shiller at Yale University, based on cyclically adjusted price earnings ratios (CAPE), both indicate that the US stock market has been very substantially over valued. Although the data for other markets, including the UK, is not as reliable, the very high degree of correlation between most of the major European markets with that of the United States implies that they too were very vulnerable to correction of such over-valuation in the US. We believe that using such techniques does provide a useful guide to the relative value of equity markets. The graphs below illustrate how these two benchmarks indicate the relative over-pricing of US equities. Both CAPE and ‘q’ have been very closely aligned in respect of valuation of the US stock market until quite recently. CAPE indicates that even at current levels the US stock market is over-valued by some 40%. ‘q’ on the other hand appears to indicate that stocks are now at fair value. However the ‘q’ result can be ascribed to statistical discontinuities in the way in which the Fed adjusts the data it receives1, and if these anomalies are adjusted for, ‘q’ also indicates that the US stock market is over-valued by some 40%.
There is not enough consistent data available to calculate ‘q’ for stock markets other than for the US, but given, as mentioned above, the high correlation between the US markets and those of Western Europe there must be a significant probability that adjustments to correct for over-valuation in the United States will have an important impact on European stock markets. As the above graphs demonstrate there is a considerable amount of fluctuation around fair value, and it is by no means certain (or even likely) that once share prices have reached fair value they will remain there. If we look at the causality of the recent fall in share prices one of the most important factors has been the credit crunch. Those banks and financial institutions who fund a significant part of their loans and/or investments through the wholesale banking markets found that, as a result of declining confidence, they were unable to fund themselves to the extent or at the rate required by their business model. This under-mined confidence in their viability. What initially was a liquidity problem thus also became a solvency problem. As the ability of banks to fund themselves in the inter-bank markets substantially reduced, their willing-ness and ability to lend to corporates also reduced. This situation has been exacerbated by the fact that there has been a massive expansion of credit which has been financed outside the banking system. Hedge funds and others have borrowed very large amounts of money to buy packages of debt. This was often financed without direct borrowing from banks by issuing commercial paper. At a time when a significant amount of de-leveraging needs to take place the availability of credit outside the banking system is also shrinking. The banks are in no position to take up the slack. In addition it is worth bearing in mind that one of the most important purchasers of equities over the last few years has been the corporate sector buying back their own stock. Their ability to do this has been facilitated by higher than average profit margins. There is increasing evidence of a recession in a number of different developed markets, not least the United States, and it is reasonable to suppose that corporate profit margins are likely to move from above average to below average in these difficult economic circum-stances. Previous research of Smithers & Co. has indicated that data in respect of corporate debt in the US and in the UK needs to be carefully interpreted and understood, and that the level of such debt is in reality considerably higher than is actually realised. It therefore seems likely that corporate buy- backs will be less prevalent in the future and investor interest will have to be found elsewhere to replace this missing component of market demand, while at the same time the result of previous corporate buy-backs will have left corporate balance sheets more stretched than they otherwise would have been. It is therefore an unfortunate fact that at the time when trustees need to look to their corporate sponsor to make good any investment performance deficiencies in their portfolio to ensure that they remain fully funded the corporate sponsor will probably find it increasingly difficult to finance the shortfall. In these increasingly uncertain times it is therefore more important than ever for trustees of pension funds to understand the economic factors which affect market movements. Given the speed at which events are taking place in the international money markets, the banking system and equity markets around the world, and the growing intrusion of politics into the mix, forecasts, ‘especially about the future’, as Sam Goldwyn would say, are extremely hazardous. However it is possible to have a grasp of what are the key issues that can have an impact on a portfolio, and to put into context some of the volatile movements that asset and money markets have seen recently. It is possible, indeed essential, for trustees to develop as good an understanding of the economic risk landscape as they possibly can, in order to assess the implications of these events as they unfold and to understand their potential impact and consequences on the investment decisions which they must make. This is a time to focus on the issues of asset allocation rather than tactical investment.
Madoc Batcup
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