Traps for investors in these uncertain times
The strong rally in global share markets has many professional investors shaking their heads. The strong evidence of economic damage that may takes months or years to repair means that many have taken little advantage from the 40% plus rallies in major indices. There is a well-known saying: "The economy is not the market, and the market is not the economy."
The recent strength in share prices illustrates this well. The share markets looks forward, anticipating developments in the real economy and its impact on company bottom lines. It's clear that many investors anticipate a strong bounce back in economies globally, and that at least some of the massive central bank stimulus funds are finding their way into stocks.
The biggest beneficiaries of the positive surprise are individual investors. While many analysts and fund managers continue to issue warnings of another leg down in share markets, retail brokerage houses are seeing net buying by their clients.
While this is good news for those investors who stepped up the plate in April and May, there are still traps for investors. No-one knows the future, but uncertainty is higher than usual in the current market. This means some of the important factors that guide investors are less reliable than under the conditions that prevailed over the previous decade.
Investors often use price to earnings ratios (P/E) as a rule of thumb. It's a straightforward assessment of the value of a stock or index, especially when compared to previous P/E levels for that instrument. Investors may also use it to choose between shares or markets, often opting for the lower P/E choice as a sign of better value.
There are limitations to the usefulness of P/E ratios, just as there are for any single measure of a stock. One example is the P/E of resource stocks. Historical analysis suggests it is better to buy mining and energy stocks on a higher P/E, and sell them on a lower one. This is because investors tend to look through the commodity cycle, anticipating turns in commodity prices and bidding up or selling down stocks in anticipation of a swing in the sometimes years long commodity price trends.
Nonetheless, P/E ratios remain a popular and useful measure of industrial stocks, and share markets as a whole.
The uncertain outlook means the P/E ratio is a less reliable measure at the moment. Over the recent corporate reporting season many companies revised or withdrew their earnings guidance to shareholders. This seems a sensible response to the highly fluid economic outlook.
However, analysts are still required to estimate earnings. These estimates rely on a lot of variables: how many widgets will the company make, what will it cost to produce them, for how much can they sell them? The often wide spread of analysts' company valuations reflects the fact that there is honest disagreement about these variables.
The current uncertainty about how economies will recover makes these estimates less reliable than usual. This means that earnings, and therefore the P/E ratio, may be subject to substantial revision. Investors should be cautious about relying on P/Es in the current circumstances.
Investors have good reason to be wary of many other investment ratios at the moment. Price to cash Flow, Price to Book, and Price to Sales are in this category. Possibly the most important warning should be to take care with dividend yield calculations.
Income from share portfolios is highly prized, especially by investors in retirement or living on this income, for whatever reason. A balanced portfolio may contain a mix of income producing assets, including property, bonds and dividend paying shares. Calculating dividend yields of stocks played an important role in the investment process over the previous decade.
However earnings uncertainty means that the future value of dividends is even harder to estimate. Not only could earnings fall, but companies may cut pay-out ratios to retain capital and strengthen balance sheets. Bank shareholders have already experienced this phenomenon, as the majors cut or deferred dividends at their most recent reports.
It's unlikely these cuts will be limited to the financial sector. Now more than ever, it is important that investors do their homework, by drilling into reports and deciding for themselves if a company's prospects deserve justify investment.