Equity markets: two mistakes to avoid.

FIRST MISTAKE

If we listen to what many “specialists” are saying, it would appear that equity markets are currently cheap since they have dropped significantly. In fact, they have not dropped in the real sense of the word. They have merely and brutally reconnected with a structurally downward trend that started in June 2007. That period corresponded to the former CAC 40 peak of 6168.

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Let us ignore those specialists who predicted that the CAC would hit 10000 in September 2000 when the Parisian index reached its all time high of 6944 on the 04/09/2000. Over the past 18 months, these same specialists have stuck with the idea that the index would evolve between 4500 and 5500. The author of this article has been betting on a CAC level of 2500 that he believes will be reached by the end of 2011. He even thinks that it will go lower than that and get back to the levels last seen in March 2003 and March 2009. Recent articles can be recommended to the readers: “What future for the CAC 40” (September 2010) and “Equity markets: upcoming crash in 2011” (December 2010). An article based on several economic grounds (macro, micro…) is currently being written to further support those downward projections.

In reality, markets keep getting it wrong when they consider that equity risk premium is big enough. This naturally leads a lot of equity valuation specialists to highlight how attractive equities are because of the huge risk premium present in this asset class. This has become even more frequent with the recent drop in equity markets. It is true that this it is quite easy to come to the conclusion that equities are undervalued when government long term interest rates (currently standing between 2% and 2.5%) are used to discount future returns. The problem however consists in selecting a proper long term interest rate to value Euro Zone equities in 2011. If we take forward rates (known simply as forwards) or forward rates with a risk premium linked to risk aversion or even the average rate of Eurozone government bonds (we could include bonds issued by banks or highly cyclical corporates), the story is not the same and the undervaluation does not appear so obvious. This is further complicated by the fact that the previous analysis does not include potential changes in regulatory and prudential frames that may discourage equity investment. Banking and insurance company share offerings will also be impacted due to recapitalization requirements.

FIRST CONCLUSION : Despite the violent drop observed on equity markets during the past three weeks, equity shares may not be as cheap as they seem.

SECOND MISTAKE

As previously mentioned in a former article, supporting long term equity investment on the grounds of expected corporate profits (which will generate a positive return on investment) can be considered as completely absurd.

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Any new investor should ignore trade recommendations telling them that equities always revert to their former value! Just ask the investors who suffered from the dot com crash what they think about that. Some notable examples are Alcatel (Highest recorded share price: 97 euros. Current share price: 2.4 euros), France Telecom (Highest recorded share price: 219 euros. Current share price: 13 euros) and Vivendi (Highest recorded share price: 140 euros. Current share price: 16 euros). When the markets get it wrong when it comes to evaluating the macroeconomic growth model of companies and consequently their valuation, there is simply no chance for the share prices to revert back to their original level. The mistake of the markets at the start of the new century’s first decade has been to believe that the virtual economy would replace the traditional real economy.

The markets have equally been mistaken in the valuation of the banking and insurance sector during the 2004 – 2006 period. This was due to the underestimation of systemic risk (subprime during 2006 – 2007, peripheral Eurozone countries during 2009 – 2011 and perhaps non peripheral soon). The mistakes have been compounded by the fact that markets have ignored the changes in regulations (which have been accelerated by the increase in systemic risk) imposed by Basel 3 and Solvency 2. These changes have brought fundamental changes in the traditional bank business model by imposing new standards on such things as liquidity and capital levels. This has contributed in slowing the progress of bank profits. It can be argued that just as technological shares such as Alcatel, Vivendi and France Telecom will never revert back to their levels last seen in 2000 (because of the mistakes in the valuation of their economic model back then), the major banking shares will never get back to their 2006 – 2007 levels due to the changes in the economic and regulatory context which they are currently facing.

SECOND CONCLUSION : Contrary to a widely spread belief, it is possible that an equity investor may never see the original level of the shares again….Many shares are currently in this situation.