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Macroeconomic Factors and Global Equity Valuation

There are several ways to define the “value” of a security.  An analyst can use an income approach, an asset-based approach, a market approach or several others that assign some quantitatively derived value to a business (and hence, the share price.)  Valuing any asset is difficult, from equities to fixed income, to options and real estate.  But ultimately, there is only one effective way to determine what a company (or any financial asset, for that matter) is truly worth at any given point in time.  A company (or an asset) is worth what someone is willing to pay for it.  

Over the past several months, investors have witnessed an unprecedented move in the equity markets toward a “macro-economically” driven value of the broad stock markets.  Improving corporate earnings, dividend increases, share-buybacks, above-estimate revenues have all had very little to do with broad share prices.  The eight hundred pound gorilla in the room is (and will likely continue to be for some time) the rapidly escalating debt situation in the European Union.  

As the Bloomberg headlines tick by day-by-day, a trend is emerging.  “Equity Markets Retreat on European Debt Contagion Fears.”  Two days later:  “Equity Markets Soar on Renewed European Debt Optimism.”  Later that day:  “Equity Markets Give Back Gains on Renewed Debt Concerns.”  The whipsawing nature of the macro-trend is a nerve-wracking blend of humorous and terrifying.  

In the absence of broad threats to European sovereign debt, the case for stocks is quite compelling.  With treasury bond yields hovering around 2% (for the ten-year) and the S&P 500 yielding better than 2.5%, just making the case for cash flow is easy.  Couple that with the historically low interest rate environment through which we’ve been plodding for the last several years and the potential for the treasury bond bubble to burst if demand for U.S. debt softens, there is not only the risk that treasury bonds will produce little yield, but also suffer a substantial loss in value over the next five to ten years.  

The case for stocks is strengthened still by evaluating the Price/Earnings ratio of the S&P 500 over the last ten years.  

Over the last ten years, the price to earnings ratio of the S&P 500 (as seen above, courtesy Bloomberg, LP) has had a steady downward trend.  During that period, however, the market has remained flat (although extremely volatile.)  Those factors together present an equity market that is comparatively cheap when viewed next to other asset classes.  

Looking at the P/E ratios of other developed nations, the story is very similar.  So what, then, is driving people away from (or at least preventing them from acquiring) equities right now?  

The short answer is: uncertainty.  Uncertainty about the governmental leadership, both domestically and abroad.  Uncertainty whether or not Europe will be hit by another (perhaps severe) recession.  Uncertainty about whether or not a European recession will cascade into a U.S. (or even a worldwide) recession.  

Economics has always been an uncertain science.  Predicting the motion of celestial bodies and subatomic particles is simple: both follow a set of rules dictated by physical laws.  Economics, on the other hand, follows rules dictated by humans, a notoriously irrational species.  It will take a resurgence of confidence in the system to drive people back into the equity markets en masse.  What will create such a resurgence in confidence?  That remains to be seen.  

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.