Are stock prices getting ahead of themselves?

WATCHING Bloomberg television and the CNBC one gets the impression that there are currently several opinion camps in the investment world. There are those economists who passionately believe that global stock prices are getting ahead of themselves and there are those who believe that the best is yet to come.

By Ramnathan

Published: Mon 7 May 2007, 8:28 AM

Last updated: Sat 4 Apr 2015, 10:56 PM

There are those who believe that there will be an interest rate cut sooner rather than later and others who don't. The words "bubble" and "recession" have been in frequent use for the past few years but one hears them more often these days. To top this all, there was this headline in the Khaleej Times of May 4, 2007, which read "Markets ignoring obvious dangers". It was a wonderfully written piece by Larry Elliott and the "black swan" analogy was particularly insightful.

I will not spend space talking at length about the risks facing the markets — be it the housing bubble or higher interest rates in China/New Zealand/UK/much of eurozone or the continuing carry trade in yen or the prospect of "imported" inflation in US due to the falling dollar. These risks are well known and the markets currently seem to be ignoring them.

Without any question, there are stock markets around the world which have gotten ahead of themselves. While India is one such market, I think China is a better example of a market which has gotten well ahead of itself. As Ed Rogers says in his insightful piece "So much greed , so little fear in China". From Shanghai's market close of 1,161 on December 29, 2005, to the 3,584 market close on April 20, China's largest domestic equity market has risen 209 per cent. Not surprisingly this rise in values has been accompanied by an even larger rise in daily turnover. In the final six months of 2005, total domestic turnover (Shanghai and Shenzen exchanges) averaged $1.67 billion per day. In 2006, total daily turnover averaged $4.1 billion per day. In the first quarter of 2007, daily notional turnover averaged $11.1 billion per day, a rise of 567 per cent in fewer than 18 months. These are well beyond Internet bubble type numbers. Our thesis is that the rising volumes of retail accounts, and the greed of the average investor in China is what is driving the markets to record heights on a daily basis. This looks, tastes and feels very much like the US Internet bubble of the late 90s, or even the Japanese asset bubble of the late 80s.

Year-to-date, Shanghai is up almost 40 per cent, and Shenzen up almost 90 per cent. That is what happens when one million new retail accounts open up each week. We don't know when the crash will come, but we do know it will be quite ugly when it happens. We all know what happens to global markets when China corrects. February 27, 2007 is, I am sure, fresh in everyone's memory. Having said all this, the Chinese government is doing all it can to discourage rampant speculation. With every "man on the street" clamouring to open a brokerage account, this job is not going to be easy but if any government can do it, it is the Chinese government.

While there are several "emerging" markets round the world which have gotten ahead of themselves, there are also markets which offer value — Brazil and few others come to mind. What about markets in developed economies though? We are seeing a world where there is sustained global growth which is helping not only the developing economies where the spending is happening but also the economies of the OECD nations.

One commentator on television remarked the other day that the Dow Jones Index is not an an American stock index anymore — it is a global stock index. This is because, he opined, that most of the largest companies listed in America have significant (in most cases more than 50 per cent) income streams emanating outside the US. This is the reason why you see healthy employment numbers in most OECD countries.

The earnings season is well into its third week and we hear about more surprises on the upside than on the downside. Mergers and acquisitions remain strong and companies in general are sitting on piles of cash. Steve Forbes summed it up nicely in the very title of his article "Golden Times — even if don't know it"

And equity guru, Ken Fisher calls it "the very first time in modern history that we have seen prolonged worldwide interval of equity artbitrage." That is where you borrow money to buy stocks and this is profitable and worthwhile because the earnings yield on equities is more than the cost of borrowings (ie after tax interest rates). He goes on to say that "this year the global equity supply will shrink by 5 per cent, or $1.75 trillion. That dwarfs the things that people worry about, like the US deficit, the cost of the Iraq war or the likely losses of principal on subprime mortgages."

So what is my call? Do we follow the old adage "Sell in May and go away"? Not really. Writing late last year, I had predicted earnings buoyancy and possible PE expansion in 2007. I can see that actually happening now. Inspite of the PE expansion, OECD markets are, in general, not wildly overvalued. I also don't see any let up in global growth any time soon and there are several emerging markets offering genuine value. In short, I see higher stock prices in the months ahead. Of course, there will be corrections along the way but the general trend in the next several months will be higher. Stay invested but choose your fund managers carefully. Happy investing.

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