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Global equity markets - Is there any value left?

17 May 2007 Nedgroup Investments (IOM)

Global equity markets have had a very good run over the past four years, raising the question; 'Is there any value left?'

In addressing this question, we first consider equity market valuations. The S&P500 price earnings ratio is now 17.5x, as compared to the long term average of 16x. So, by this measure, the US equity market is fairly valued to a bit expensive. However, which way the market goes from here depends on future earnings. The consensus estimate for 2007 earnings growth is 6%; and for 2008, 11%. If earnings exceed these forecasts there is potential for upside in equity markets. Valuations are similar in Europe. We must though be cautious about forecasting equity market direction based upon one simple measure. History shows that equity markets can sharply overshoot or undershoot long-term averages.

Another measure of stock market value is to compare stocks to bonds. If you buy the S&P500 now, you receive an earnings yield of 5.7%, whereas US bonds in the ten-year sector yield just 4.7%. The current ratio of these is 1.21, and plotting this ratio over time shows that stocks appear attractive relative to bonds.

In order for stock prices to climb, there must be net new buying. One potential source of buying is cash from mutual funds. When mutual funds are holding plenty of cash, this is positive for stock markets, as it represents a pool of money available to drive stock prices higher. When mutual funds are holding very little cash, they have less to deploy into the market. Over the past 40 years, mutual funds have held cash balances of between 4% and 12%. They currently hold just 4% in cash and this indicator is, therefore, bearish for the US stock market.

Another source of liquidity is from individuals. In the US, individuals can put down 50% of the cost of buying a stock and borrow the other 50% from their broker on margin. Margin debt on the New York Stock Exchange has been increasing and currently stands at $300bn. In the short run, this is positive for the stock market. However, in the medium term this debt has to be paid back. In a down market, there will be some forced sellers who must liquidate their positions in order to pay back their brokers, which is what happened in the last bear market from 2000 to 2002. This indicator is positive in the short term, but negative in the medium term.

International money flows also drive stock prices with some Asian savings finding their way into western stock markets, US bonds and credit spread product. A more recent money flow is recycled petrodollars. The resulting large pools of Middle East oil wealth are invested primarily in stocks and bonds of the US and Europe, which has helped to drive up prices in these markets. In forecasting equity market direction it is important to understand both valuation measures and money flows.

Within equity markets, there are clearly pockets of absolute and relative value.  As an example, utility stocks in the US yield about 4.0%. REITs (Real Estate Investment Trusts) yield about 3.5%, whereas the yield on MLPs (Master Limited Partnerships) is much higher at 6.0%. MLPs are a relatively unknown sub-sector of the US equity market. Most MLPs are companies that hold and develop energy transportation facilities such as pipelines and, like REITs, pay out a high percentage of their earnings as dividends. At 6.0%, the dividend yield of MLPS is much higher than that for REITs, and MLP distributions are growing at a faster rate. We believe that there is excellent value to be found in this sector.

Though earnings growth in Europe and the US is past its peak, there is still very healthy earnings growth in much of the world. As long as this continues and as long as bond yields remain supportive, the current upward momentum in equity indices can be sustained. However, as the bull market matures, the best returns will be derived from careful sector analysis.

 By Larry Jones, Chief Investment Officer, Nedgroup Investment Advisors (UK)

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