Looking for the bottom

Aug 9th 2011, THE ECONOMIST

HOW does one tell when markets are cheap? Regular readers will know that this blogger has been gloomy for a while but the trick is to have some cash available so one can follow the old rule of being greedy when others are fearful. The Vix index of volatility has reached 48, the kind of levels that indicate panic. Hedge funds say there is unusually high volume for August and that there are signs of capitulation in the financial stocks, perhaps as value investors exit the sector.

Wall Street presents a problem for the cheapness argument. Ignore the historic or prospective p/e (much beloved by analysts and CNBC) since they won't mean much of the economy weakens. The best measure is the cyclically-adjusted p/e ratio which averages profits over a decade and pointed to market tops in 1929 and 2000, as well as the early 1980s. According to Professor Shiller, the ratio was 20.7 at the end of last week, whicn makes it around 19.5 after yesterday's fall. That is still above the long-term average of 16.4. The dividend yield is between 2 and 2.5%, on the FT's various measures; even adding 0.5-1% for buy-backs doesn't make that look cheap.

Things are more hopeful in Europe. for the continent as a whole, Andrew Lapthorne reckons the cyclically-adjusted p/e is 12.4; that is still 20% above the 2008 low but it still a lot more attractive than the US. Remember also that many European companies have prospered by selling to emerging markets.

In Britain, the dividend yield on the All-Share is a full percentage point above the yield on gilts. In other words, the market is pricing in future dividend cuts. The crossover between these yields was a good buying point in 2003 but didn't stop the markets from falling further in 2008. One needs also to remember that the dividend yield was higher than gilt yields throughout the first half of the 20th century; the current situation may be a return to normal or could simply indicate that gilts are very expensive. The old rule of thumb used to be that yield of more than 5% made the market cheap; we are now around 4%. Events in London are hardly conducive to market confidence.

For emerging markets, Morgan Stanley reckons the price-to-book ratio is 1.65. that is below the average of the last 20 years although it's worth noting that prices fell to book in 1998. For what it's worth, MSCI reckons the forward p/e of emerging markets is now in single digits.

So there are certainly signs of value outside the US, although the case is not overwhelming. An alternative view is simply that equity markets are catching up with the message that government bond yields have been sending all year, and that has been implied by central bank policy; the developed world economy is still very weak.

Dylan Grice at Societe Generale is one of the top rated strategists in London who has long argued for an overweight cash and long gold position. He thinks the markets are pushing the central banks to monetise the issue; with the Fed indulging in a third round of QE and the ECB loosening the purse strings to buy unlimited bonds. However, he thinks it may take more of an air of crisis before the authorities finally capitulate; perhaps a big European bank in trouble or if French yields start widening towards Spanish levels.