12x for 2012?

Having travelled in that part of Mexico, I have nothing but respect for Mexicans with Mayan heritage and sympathy for the way in which their traditional culture has been appropriated by a bunch of new-agey kooks.

That said, it looked like 2011, not 2012, was going to be the end of the world as the legislative branch of the US government threatened to stop financing the executive branch and the nations of the Eurozone dithered their way through a break-up crisis resolving eventually to stay together for the sake of the children (and their bondholders).

As an asset manager we watched corporate profits continue to grow as the global economy lurched forward.

Table 1 - Growth Rates: Global Equities
With equities delivering above-average growth in sales, cashflow, profits and book value, the not-so obvious question is why did global equity markets fall nearly 10% in 2011?

Well, the short answer is that people sold their stocks, even though the companies were making money, because they were worried about “risk”.  With the sell-off of 2008 fresh in everyone’s mind, it was easy to frighten people into selling their shares at a loss.  In short, becuase of fears about the amount of government debt, people sold their equity in profitable companies and then loaned their money to governments.  This was considered a ‘risk-off’ trade by market pundits.

However, the typical risk-off trade of 2011 has gotten very crowded, and we’ve seen the risk trade take a different turn.  The CBOE Market Volatility Index, a specialized futures contract that is used to determine the settlement prices of options on the S&P 500, fell almost 20% in December.  The dollar volume of trading in this risk-management (or risk magnifying – depending on whether you’re short or long) has fallen 93% from its peak a few months ago.

This is very good news for longer-term investors.  If the demand for ‘portfolio insurance’ has dropped while the price of insurance has also dropped, it’s a sign of improving confidence in equity markets.  Traders are moving away from trading ‘risk’ and back to trading equity.

Still, for all of the concern about risk and volatility, publicly traded companies continued to do well.   The aggregate earnings of public companies hit a record high of $3.63 trillion in 2011 even though global stocks are still valued 22% below their all-time high.

On a forward-looking basis, stocks haven’t been this undervalued since Q1 2009.  Over the next twelve months, the global price-earnings ratio increased from 10x to 12x and stocks rose 72%.

Forward P/E ratios are once again 10x.

A return to 12x in 2012 would boost stock prices significantly – and we’d still be undervalued compared to the long-term averages.

With equities delivering above-average growth in sales, cashflow, profits and book value, the not-so obvious question is why did global equity markets fall nearly 10% in 2011?

Well, the short answer is that people sold their stocks, even though the companies were making money, because they were worried about “risk”.  With the sell-off of 2008 fresh in everyone’s mind, it was easy to frighten people into selling their shares at a loss.  In short, becuase of fears about the amount of government debt, people sold their equity in profitable companies and then loaned their money to governments.  This was considered a ‘risk-off’ trade by market pundits.

However, the typical risk-off trade of 2011 has gotten very crowded, and we’ve seen the risk trade take a different turn.  The CBOE Market Volatility Index, a specialized futures contract that is used to determine the settlement prices of options[2] on the S&P 500, fell almost 20% in December.  The dollar volume of trading in this risk-management (or risk magnifying – depending on whether you’re short or long) has fallen 93% from its peak a few months ago.

This is very good news for longer-term investors.  If the demand for ‘portfolio insurance’ has dropped while the price of insurance has also dropped, it’s a sign of improving confidence in equity markets.  Traders are moving away from trading ‘risk’ and back to trading equity.

Still, for all of the concern about risk and volatility, publicly traded companies continued to do well.   The aggregate earnings of public companies hit a record high of $3.63 trillion in 2011 even though global stocks are still valued 22% below their all-time high.

On a forward-looking basis, stocks haven’t been this undervalued since Q1 2009.  Over the next twelve months, the global price-earnings ratio increased from 10x to 12x and stocks rose 72%.

Forward P/E ratios are once again 10x.
 
A return to 12x in 2012 would boost stock prices significantly – and we’d still be undervalued compared to the long-term averages.

This can only happen if the ‘risk –off’ trade loses its allure.  With bonds yielding less than inflation and trading in the VIX down 93%, it seems like this is starting to happen.

1 We have a hard time imagining something with as much risk as owning bonds that yield less than the prevailing rate of inflation.

2 Options on the S&P 500 are normally bought by investors as ‘portfolio insurance’ which pay out if the market declines.  The VIX is a good indicator of the prevailing cost of ‘portfolio insurance.’

3  5-year average is 12.9

   10-year average is 14.2

   25-year average is 15.8