JOHANNESBURG – The sell-off in global equity markets is deepening. Since the beginning of October developed market equities as measured by the MSCI World Index in terms of US dollars by Monday was down by 6 percent, the US market (S&P 500 index) down by 6 percent and emerging markets as measured by the MSCI Emerging Market index in terms of US dollars down by 7 percent.
Locally, the FTSE/JSE all share index lost 6 percent in terms of rand and 7 percent in terms of US dollars while the FTSE/JSE Financial and Industrial index lost more than 7 percent in rand and more than 8 percent in terms of US dollars. We all know that a correction from overbought and high valuations was inevitable. The big question now is: How low can we go?
I take my cue from Nobel laureate and Yale University economics professor Robert Shiller’s cyclically adjusted price-to-earnings ratio (Cape), which uses smoothed real earnings over a 10-year period to eliminate the fluctuations in net income caused by variations in profit margins.
The Cape of the S&P 500 Composite Index has been in an up-trend since its lows in early 2009 and my research proved that the valuation is driven by consumer confidence. The US market valuation peaked in January this year when the Cape of the S&P 500 composite index reached 33 points and is currently at 31 points.
My analysis of the upward channel indicates that the valuation level may fall to 28 points and still remain in the up-trend since 2009. This indicates that the US market may retreat another 10 percent and still remain in a bull market.
A similar analysis (my calculations) for developed markets, as measured by the MSCI World index in US dollars, suggests that its Cape followed the trend of the US market valuation and hit a high of 25 points in January and retreated to the current 22.6 points. It also suggests that developed market equities may pull back another 11 percent and still remain in a bull market.
I also used Shiller’s methodology to value the South African market. In October 2012, the FTSE/JSE Financial & Industrial index’s cyclically adjusted price-to-earnings ratio caught up with that of the S&P Composite index and followed it until April 2016, after which it diverted as investors shunned South African stocks. It caught up with the Cape of developed market equities until March this year, but has plummeted since then as politics, domestic economic factors and risk off strategies saw a global sell-off of emerging market assets.
My analysis indicates that the FTSE/JSE Financial & Industrial index is currently trading at a discount of 18 percent compared to the developed market equities after it traded at a massive premium of more than 38 percent in November 2015. It is the widest discount since July 2008.
In comparison, the SA market as a whole as measured by the FTSE/JSE all share index traded, roughly speaking, on par with the Cape of developed market equities from 2006 until 2016. Thereafter valuations plummeted to a discount of 26 percent currently - the widest discount since June 2005.
How things will pan out in the coming weeks is impossible to say. Only time will tell whether we will see the market steadily absorbing the recent sell-off and reduced volatility or a further 10 percent sell-off. A bear market is generally defined when the price of an investment falls by 20 percent or more from its 12-month high.
So, another 10 percent drop in global equity indices such as the S&P 500 will not mean that we will find ourselves in a bear market yet. What I know, though, is that global business sentiment and consumer sentiment must have taken a hit by the sell-off of riskier assets, while global political and economic tensions are likely to remain elevated.
Global equity markets may adjust to changed circumstances in a relatively short space of time - that’s volatility. With regard to South African equities, how wide must the discount to developed market valuations be before foreign and domestic investors will be enticed to enter our market again? Before emerging markets became popular in the previous bull market the discount of our equity market as measured by the Cape of the FTSE/JSE All Share Index was more than 40percent against developed market equities.
Yes, the falls in the markets are uncomfortable,but we are not at panic stations yet.
Ryk de Klerk is an independent analyst: contact [email protected]
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