Stocks are now down more than 10% from their recent peak--an official "correction."
So what does that mean?
Is it a "buying opportunity"? Are stocks cheap?
Not necessarily.
Over the short-term, the market could certainly snap back. And if the carnage keeps up, Ben Bernanke might announce some huge new quantitative easing program in addition to his zero-percent-interest-rates-forever policy. Or Congress might panic about the elections and suddenly address "Taxmageddon" and the fiscal cliff. Or Europe might suddenly bail out all its banks and kick the can down the road for a while.
And those initiatives might boost stocks.
On the other hand, stocks could now keep dropping until they enter a "bear market" (20% decline), or worse.
On that score, the bigger valuation picture is still not that encouraging, at least for long-term returns. Even after the recent pullback, stocks are still about 20% overvalued when measured on Professor Robert Shiller's "normalized" earnings--earnings adjusted to normalize profit margins. This is is one of the only valuation measures that actually bears some correlation to long-term future returns. (PEs based on a single year of earnings can often be highly misleading).
Specifically, even after the pullback, stocks are still trading at 20X cyclically adjusted earnings. As we can see in the following chart from Professor Shiller, over the past century, stocks have averaged about 16X those earnings. So we're still about 20% above "normal."
Importantly, though, 20X is a lot closer to normal than the ~24X recent peak. Stocks certainly aren't "cheap," but they're also not wildly overvalued anymore.
Wait, what are "normalized" earnings? Aren't stocks now astoundingly "cheap"?
In recent months, eager to suggest that stocks are cheap, most analysts have talked about the market P/E ratio relative to next year's projected earnings. And relative to those earnings, stocks do seem modestly "cheap" (12X, or something).
Unfortunately, measuring stock values against next year's projected earnings has a couple of flaws. First, no one knows whether those projections will materialize. Second, and more important, those projected earnings assume that today's record-high profit margins (see below) will persist.
St. Louis Fed
Over history, corporate profit margins have been one of the most reliably "mean-reverting" metrics in the economy. When margins get extended to super-high (today) or super low (2009) levels, they generally revert toward the mean. This radically changes the PE ratio.
Using single-year earnings often provides a very misleading impression of how "cheap" or "expensive" stocks are. When profit margins are abnormally high, as they are now, the PE seems misleadingly low. And when profit margins are abnormally low, as they were in 2009, the PE seems misleadingly high. The "normalized" PE ratio provides a much more meaningful view.
And measured on average profit margins, not today's super-high margins, the stock market is still a bit expensive. (We discuss this in detail here).
Sadly, this doesn't tell you anything about what the market will do next. As you can see in Professor Shiller's chart, the market has spent decades above and below the average.
What this PE ratio does tell you is that stocks still have lots of room to fall--20%, just to get back to normal, much more than that if they "overshoot."
And it also tells you that long-term returns are still likely to be sub-par. Through history, one of the most reliable predictors of next-10-year returns is the valuation level at the beginning of the period. Today's valuation level is not as high as yesterday's. But it's still higher than average.
But we're getting closer to "fair value." And that's good news for long-term investors who want a compelling long-term return. And bonds are now so expensive that stocks are highly likely to produce better returns than bonds over the next decade, even if the stock returns are sub-par.
See Also: ALBERT EDWARDS: The Stock Market Will Collapse To New Lows And All Hope Will Be Crushed
Cyprus would seek EU bailout money 'if necessary' - BBC News
Cyprus appears to be edging closer to a bailout, with the central bank governor saying that the country will seek European Union aid if necessary.
The comments by Panicos Demetriades, made in an interview with the Financial Times, echo remarks on Friday by president Demetris Christofias.
Cyprus had previously firmly rejected suggestions of a bailout, but its banking system is exposed to Greece.
Mr Demetriades told the FT that Cyprus was at "an important crunch time".
At the end of June, the Cyprus Popular Bank faces a deadline to find at least 1.8bn euros to meet new EU capital requirement rules.
There is a growing belief among analysts that the money will have to come from the European Financial Stability Facility.
On Friday, Mr Christofias told a news conference: "I don't take as a given that we will negotiate entry to a support mechanism, (but) I don't want to absolutely exclude it."
'Chaotic situation'The Cypriot financial system has an exposure to Greece estimated at 23bn euros, compared with the size of the Cypriot economy of around 17.3bn euros.
Mr Christofias said officials are looking at contingency planning to "deal with a chaotic situation" if Greece leaves the eurozone.
"It is something I hope will never happen," he said.
Last year Cyprus, who credit status has been downgraded to junk by two of the three main ratings agencies, borrowed 2.5bn euros from Russia.
In his FT interview, Mr Demetriades, who became governor only last month, said further private sector or government borrowing might be possible.
But he said: "There is a backstop there and the backstop is the European Financial Stability Facility, and that backstop will be used if necessary."
Egypt Stocks Slump to Two-Month Low on Verdict, Global Economy - Businessweek
Egypt’s stocks tumbled to the lowest level in almost two months after the verdict in the trial of former President Hosni Mubarak sparked protests and on concern global economic growth is slowing.
Orascom Construction Industries (OCIC) declined to the lowest intraday level since April 22. Ezz Steel, the country’s biggest publicly traded manufacturer of the metal, lost 1.5 percent. The benchmark EGX30 Index (EGX30) dropped 1.9 percent to 4,599.13, the lowest intraday level since April 11, at 11:09 a.m. in Cairo.
A Cairo court handed life sentences to Mubarak and his interior minister Habib El-Adli for complicity in the deaths of demonstrators during last year’s apprising. It also acquitted six assistants of El-Adli of the charges related to the killings and Mubarak’s two sons of corruption charges. All decisions are subject to appeal. Thousands of demonstrators filled Cairo’s Tahrir Square within hours of the verdict to voice their discontent.
“Today’s market is definitely politically driven and the global scene is not helping make things better,” said Omar Darwish, equity sales trader at Cairo-based Commercial International Brokerage Co. “People are back in Tahrir demanding the fall of the regime as if nothing had happened over the past year and a half and this may result in the delay of the presidential election.”
EFG-Hermes Retreats
European stocks declined for the fourth week in five and U.S. shares tumbled, erasing the Dow Jones Industrial Average (INDU)’s 2012 gain. Oil dropped 3.8 percent in New York on June 1 after the Labor Department said American employers added the fewest workers in a year in May. The jobless rate in the euro region, which has been in the grips of a debt crisis for three years, reached a record high, of 11 percent in April and March.
Orascom Construction, the country’s biggest publicly traded builder, lost 1.3 percent to 254.5 pounds. Ezz Steel (ESRS) slipped to 6.55 Egyptian pounds, poised for the lowest close since April 11.
EFG-Hermes Holding SAE (HRHO) lost 0.6 percent after the biggest publicly traded Arab investment bank rejected a takeover bid from Planet IB Ltd. in favor of a joint-venture with Qatar’s QInvest LLC.
To contact the reporter on this story: Ahmed A Namatalla in Cairo at anamatalla@bloomberg.net
To contact the editor responsible for this story: Claudia Maedler at cmaedler@bloomberg.net
Look beyond interest rates to get out of the gloom - Financial Times
With the past week’s dismal US jobs data, signs of increasing financial strain in Europe and discouraging news from China, the proposition that the global economy is returning to a path of healthy growth looks highly implausible.
It is more likely that a pessimistic view is again taking over as falling incomes lead to falling confidence that leads to reduced spending and yet further declines in income. Financial strains hurt the real economy, especially in Europe, and reinforce existing strains. And export-dependent emerging markets suffer as the economies of the industrialised world weaken.
The question is not whether the current policy path is acceptable. The question is what should be done? To come up with a viable solution, consider the remarkable level of interest rates in much of the industrialised economies. The US government can borrow in nominal terms at about 0.5 per cent for five years, 1.5 per cent for 10 years and 2.5 per cent for 30 years. Rates are considerably lower in Germany and still lower in Japan.
Even more remarkable are the interest rates on inflation-protected bonds. In real terms, the world is prepared to pay the US more than 100 basis points to store its money for five years and more than 50 basis points for 10 years. Maturities would have to reach more than 20 years before the interest rates on indexed bonds become positive. Again, real rates are even lower in Germany and Japan. Remarkably, the UK borrowed money last week for 50 years at a real rate of 4 basis points.
These low rates even on long maturities mean that markets are offering the opportunity to lock in low long-term borrowing costs. In the US, for example, the government could commit to borrowing five-year money in five years at a nominal cost of about 2.5 per cent and at a real cost very close to zero.
What does all this say about macroeconomic policy? Many in both the US and Europe are arguing for further quantitative easing to bring down longer-term interest rates. This may be appropriate given that there is a much greater danger from policy underreacting to current economic weakness than from it overreacting.
However, one has to wonder how much investment businesses are unwilling to undertake at extraordinarily low interest rates that they would be willing to with rates reduced by yet another 25 or 50 basis points. It is also worth querying the quality of projects that businesses judge unprofitable at a -60 basis point real interest rate but choose to undertake at a still more negative real interest rate. There is also the question of whether extremely low safe real interest rates promote bubbles of various kinds.
There is also an oddity in this renewed emphasis on quantitative easing. The essential aim of such policies is to shorten the debt held by the public or issued by the consolidated public sector comprising both the government and central bank. Any rational chief financial officer in the private sector would see this as a moment to extend debt maturities and lock in low rates – exactly the opposite of what central banks are doing. In the US Treasury, for example, discussions of debt management policy have had exactly this emphasis. But the Treasury alone does not control the maturity of debt when the central bank is active in all debt markets.
So, what is to be done? Rather than focusing on lowering already epically low rates, governments that enjoy such low borrowing costs can improve their creditworthiness by borrowing more not less. They can also invest in improving their future fiscal position, even assuming that no positive demand stimulus effects are likely to materialise. At a time of negative real rates, accelerating any necessary maintenance project and issuing debt leave the state richer not poorer; this assumes that maintenance costs rise at or above the general inflation rate.
As my fellow Harvard economist Martin Feldstein has pointed out, this principle applies to accelerating replacement cycles for military supplies. Similarly, government decisions to issue debt and then buy space that is currently being leased will improve the government’s financial position. That is, as long as the interest rate on debt is less than the ratio of rents to building values, a condition almost certain to be met in a world of government borrowing rates of less than 2 per cent.
These examples are the place to begin because they involve what is in effect an arbitrage, whereby the government uses its credit to deliver essentially the same bundle of services at a lower cost. It would be amazing if there were not many public investment projects with certain equivalent real returns well above zero. Consider a $1 project that yielded even a permanent 4 cents a year in real terms increment to GDP by expanding the economy’s capacity or its ability to innovate. Depending on where it was undertaken, this project would yield at least 1 cent a year in government revenue. At any real interest rate below 1 per cent, the project pays for itself even before taking into account any Keynesian effects.
This logic suggests that countries regarded as havens that can borrow long-term at a very low cost should be rushing to take advantage of the opportunity. This is a view that should be shared by those most alarmed about looming debt crises because the greater your concern about the ability to borrow in the future, the stronger the case for borrowing for the long term today.
There is, of course, still the question of whether more borrowing will increase anxiety about a government’s creditworthiness. It should not, as long as the proceeds of borrowing are used either to reduce future spending or raise future incomes.
Any rational business leader would use a moment like this to term out its debt. Governments in the industrialised world should too.
The writer is Charles W. Eliot university professor at Harvard and a former US Treasury secretary
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