Think long

Oct 12th 2008
From Economist.com

Finding a few bright spots in the gloom

WHEN the dotcom bubble was in full swing in 1999 and early 2000, commentators wrote in vain about the absurdity of stock markets yielding 1-2% and trading on a price-earnings ratio of 30-40. The world had moved on, we were told, and old measures of value did not matter.

It was an illustration that valuation, by itself, does not cause markets to turn. So seeking an end to the current bear market by appealing to valuation measures may not work. Clearly, a lot of people are forced sellers, regardless of price.

Nevertheless, for long-term investors who can screw up the courage to enter the stockmarket, the odds are looking more and more favourable. This column mentioned a couple of weeks ago that British equities were yielding more than government bonds. They still do but never mind that—they now yield more than official interest rates.

As of the close on October 9, the FTSE 100 index yielded 5.3%, almost a full percentage point higher than the 4.5% level of base rates. This is unprecedented in the 43 years for which Datastream has the statistics (see chart).

The chart used British numbers because Datastream has the best history for those figures. But the same story applies elsewhere. The FTSE North America Large Cap index yields 3.1%, more than double the Fed-funds rate. The FTSE Eurofirst (Eurozone) index yields 5.7%, two percentage points above short rates in the eurozone.

Of course, dividends will be cut, particularly in the banking sector. But the level of dividend cover is respectable, more than two in Britain (in other words, there are enough earnings to pay dividends twice over). Even if one forgets dividends and looks at the price-earnings ratio, things look fairly attractive. The FTSE 100 is on an historic p/e of nine, which equates to an earnings yield of 11%. That ought to give a fair degree of protection against the inevitable falls in forecasts.

It is also possible to see bargains at the individual stock level. Both BP and Shell have a dividend yield equal to, or higher than, their p/e: an old rule of thumb for value investors. True, the oil price is falling sharply, but shares in oil companies lagged well behind the crude prices when it was soaring to $147 a barrel.

James Montier of Dresdner Kleinwort uses a value screen developed by Ben Graham, the patron saint of value investing and the mentor of Warren Buffett. He found 35 stocks in Europe that met the criteria—among them BP, Total, Ericsson and Nokia—and 125 in Japan, including Sharp and Panasonic. This, says Mr Montier, does not make him bullish on the overall market but on a basket of deep-value stocks.

A note of caution is needed. Montier finds just two stocks that meet his valuation criteria on Wall Street. And measures based on profits may be distorted because companies have enjoyed fantastic earnings growth in recent years. Smithers & Co has a measure called cyclically-adjusted p/e, which averages earnings over the last 10 years. In America, that has fallen sharply in recent weeks and is now around the historical norm of 15. But in deep bear markets, the bottom was five.

Valuation measures may be a great guide for five or ten years. But they are not much help over six months, let alone over the next day. And that is one reason why markets are struggling to find a bottom.