Investors urged not to abandon stocks

The past two weeks have not been pleasant for equity investors across the globe and the domestic market, which shed 2,9% by 15 May since its 2 May 2012 all-time high, has been no exception.

“With investors’ focus currently on the mess in Europe and the negative knock-on effect of this situation on economies across the globe, investors are obviously asking whether we are once again entering a bear market,” says Paul Stewart, head of asset management at Grindrod Asset Management.

The accompanying Chart A (top graph) shows the trailing price-earnings (PE) ratio of the FTSE/JSE All Share Index (ALSI) at the start of all bear markets (defined as a drop of 20% or more) since 1960. According to Stewart, the average PE ratio of the ALSI at the start of a bear market has been 15,6 times earnings (red line).

“Since 1960 there have been six bear markets where the ALSI traded below this average PE,” Stewart points out. “Furthermore, there have been only two bear markets (orange bars) since 1960 when the PE ratio at the start of the bear market was below the long-term average PE of 11,9.”

The bottom graph of Chart A shows the percentage decline of the ALSI during these bear markets. For the two bear markets (orange bars) that began when the ALSI was trading below the long-term average of 11,9 times earnings, the average decline was 34,3%.

“While this is below the historical average decline of 38,6%, the sixth most severe bear market since 1960 began in October 1980 when the ALSI traded at a mere 9,1 times earnings,” says Stewart. “That bear market lasted a full 24 months and saw a decline of 38,7%.”

“While the ALSI PE ratio helps us to compare the market’s valuation over different time periods, it also helps to compare the market’s historical valuation relative to alternative assets,” says Stewart. The accompanying Chart B (top graph) shows the earnings yield of the ALSI relative to the 10-year yield on the BEASSA All Bond Index (ALBI) on the specific bear market starting dates.

“As of 30 April 2012, the earnings yield of the ALSI at 7,7% was slightly below the yield on the 10-year treasury of 7,8% (relatively speaking at 0,99 on the chart). Since 1965, the date from which the yield data for the ALBI are available, there has only been one bear market that began with a ratio higher than 1,” says Stewart.

“Historical valuations of the equity market at the start of bear markets since 1960 show that although bear markets are less likely to occur when valuations are at low levels, they are still possible. While valuations remain attractive, there are many other potential variables investors need to take into account in their investment decisions.”

Stewart says that while an underweight position in equities seems to be the right strategy for now, with uncertainty and volatility likely to continue for some time to come, he believes equities still have the best return potential over the long term compared to other asset classes such as cash and bonds. “Long-term investors who can tolerate the volatility should therefore not abandon their equity positions,” he says.

Chart A - Click on images to enlarge

Chart B