Equities: The ‘fade risk’ stage on the doorstep?

JOHANNESBURG – How are your stocks doing? Would you buy a stock you knew would fall? Your answer would probably be “no way”. Would you be an aggressive buyer of equities if you do not know where stock markets are heading? Probably no.

The Noble laureate, Yale University economics professor Robert Shiller, who predicted the dot-com and housing bubbles in his book Irrational Exuberance (and a second edition) is very worried about the US stock market. His cyclically adjusted price-to-earnings ratio uses smoothed real earnings over a 10-year period to eliminate the fluctuations in net income caused by variations in profit margins.

The average monthly cyclically adjusted price-to-earnings ratio, or Cape, since 1881 sits at 16.8 and is currently more than 30 – near the pre-2008 crash levels. The market is considered to be expensive when the ratio is above the long-term average.

The use of Shiller’s methodology for the South African market makes for interesting reading. In October 2012 the FTSE/JSE Financial and Industrial index’s cyclically adjusted price-to-earnings ratio caught up with that of the S&P Composite Index and followed it until April last year after which it diverted as investors shunned South African stocks.

The de-rating of the FTSE/JSE Financial and Industrial Index continued until it reached similar levels as that of the MSCI World Index in the first quarter this year. The Cape ratio of the FTSE/JSE Financial and Industrial Index is currently approximately 23 compared to the MSCI World’s 21, rendering US stocks expensive compared to other stocks globally.

In contrast, the Cape ratio of the FTSE/JSE all share index mirrored that of the MSCI world index until August last year, but the struggling mining sector and uncertainties surrounding that sector resulted in the opening up of a gap or de-rating of the South African market as a whole with the Cape ratio of FTSE/JSE all share index currently at about 19.

Shiller has been widely criticised in the past for saying that the stock market will ultimately go back to trend and his failure to call the market cheap in 2009.

The Cape ratios of the S&P Composite Index, the MSCI world index and even our own indices pointed to stocks in inexpensive territories at the end of 2008 and first quarter of 2009.

At this stage it is important to note that the Shiller price-to-earnings ratio has only been at this level or higher before the Great Depression in 1929 and 1997 to 2001 during the dot-com bubble.

Shiller is not calling a top of the market, but in a note to CNBC in July this year he warned that the low volatility paired with high Cape ratio makes him “lie awake worrying”. It could be negative for equities “It would be pretty big. We could see a major correction. This is not a forecast. It’s a worry.” Even the traditionalists who concentrate on current and forward price-to-earnings ratios should be worried.

The current ratio of the S&P Composite index based on trailing 12-month earnings is approximately 25 and that compares to the median ratio of approximately 17 since 1954.

Manage your own expectations and emotions. The “fade risk” stage is on the doorsteps. Maintain balance between tactical, flexible managers and those with a good record of asset rotation and value preservation.

Ryk De Klerk was co-founder of PlexCrown Fund Ratings and is currently a consultant for PlexCrown Fund Ratings.

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