The deleveraged world. Welcome to 2009!

A new year, and opportunities are stacking up already. Hope readers have had a great Christmas and New Year!
Went skiing for post Christmas and New years and really enjoyed the break. A lot of work out too, apart from the skiing and iceskating.
A few familymembers got the flu and I am currently taking care of the youngest one.
Should be fine by Monday.

Now, over to the markets.

Stockvaluations - bullish, in the "old" leverage world context, not in the "new", deleveraged one.

Macrovariables that will affect the stock market;
Bullish

1) In the US, 3.7 Trn Usd has been invested in money market funds during 2008. This is 14% of the US Equity market capitalisation. With the long term average at 8%, its very high. Mean reversion exists, sure, but when this deviation adjusts is a different matter. This fact just points out that we live in exceptional times, which we already knew. Still, it is a very good reference indicator for asset allocations, which matters greatly.

2) The current fiscal and monetary approach is expected to stabilise economies (at least in the US) in the latter part of 2009.

♥ (This was typed by my youngest, dont know how she did it, but she messed up my keyboard in the process. Anyway, Ill keep it there).

3) The US bond market is facing record bond issuance in 2009, increasing risks of a setback and a shift from bonds into equities. With US dividend yields in excess of 3%, it beats the US T-bond market. This relationship is even more emphasised in Asia and will have positive currency implications there as Asian EMG has been mostly equity and FDI driven. As a reference, CEE inflows has been 80% bondmarket related. Thus, Asian EMG equity markets and currencies are to be favoured over CEE ones. China needs to keep their currency stable in this scenario though. If they dump their currency, all bets are off.

4) Share holdings of real money accounts, pension funds have reached an all time low.

5) Fiscal authorities are increasingly committed to stabilise asset prices.



Bearish- equity in a deleveraged world

The long run, the favourite equity sales story. It is time to revise it and include a new framework. Stocks are good in the long run, IF bought at the right price. Lets check out if the price is right according to the "old", leveraged world vs the "new", deleveraged one.

The Q ratio. The value of the stock market relative to the replacement cost of net assets.
Above 1 equals overvalued, below 1 equals undervalued. At 0.425 we are now at the lowest Q since 1987.

The PE ratio. Earnings per share, E is compared as a function of P, or price.
Lowest PE ratio since 1980-81. Using a 10 year moving average, valuations are still low, but less so. But, if we are to adjust for our future economy within the context of deleveraging vs leveraging, it might not look as attractive.
It seems, at least for the next few years, as if we are now moving into an environment where the government influence will increasingly substitute the freemarket forces and where regulation will overrule wild west capitalism. Corporate profits will no longer be a function of leverage and cheap financing.


It is a new world for stock market investors. The considerations below should have some bearing on Q ratios, PE ratios and, of course, stock prices going forward.

1) Reversing trends. Leverage and gearing ratios seems to be coming down. Availability of cheap financing is going down and might not return any time soon. (Excluding government fiscal stimulus and yield discounting.) Narrow yield spreads and low real corporate interest rates ditto. The historical trend of declining corporate tax rates might be bottoming out or turning.

2) Global GDP is going down and the free trade mentality is under pressure. Globally, separate ad hoc policy responses to this crisis with little or no coordination is not a good sign for future developments.

3) Management changes at the throwns of the former risk taking institutions?
The risk taking entrepreneurs of the past have been shown the exit, and the ones remaining are handcuffed. Bonuses, parachutes and executive compensation risk starting a new downward trend. This will not fit the old leverage world profile, rather the new deleveraging one, with lower testosterone levels. New rules, new management, lower hormone levels.

4) Deregulation and lower taxes trends might be coming to an end. This means lower growth for the private sector since it will affect innovation and productivity in a negative way. Profit and earnings per share growth will be negatively affected.


Summary
Stocks look cheap in the context of the old leveraged world provided by cheap financing and low corporate tax rates. However, that is a world of the past, not the the future for the next few years.

Increased regulation, lower leverage levels, increased corporate taxes, a deficit of entrepreuneurial spirits and an increased economic share of government spending will pressure the private sector, making it less productive in the process. This makes stocks less attractive and shifts the macro environment rules of stock valuation.

Lets hope the governments of the world focus on sound asset price support measures and recapitalisation of lending institutions. With the trend of governments increasingly owning financial institutions set in place, it might be a better idea to own corporate bonds instead of corporate stocks. Especially in US, due to their very focused approach of getting credit spreads down.

As I mentioned in the 1Q outlook for 2009, there will be fierce bear market rallies, and by all means, get on them. However, expect a more specific and stockpicking kind of environment with fewer outperformers and lower expectations on performance due to the future lower growth framework as mentioned above.

As usual, good luck









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