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An Update on Valuations

(September 25, 2008)

Dear Subscribers and Readers,

For those who value George Soros' opinions on the financial markets, his latest Financial Times editorial is a must-read.  In his FT editorial, Soros blasted Treasury's recent policies as one of the major reasons why we are now witnessing a $700 billion “bailout” – as well as outlining the reasons why he considers Paulson's plan as unworkable.  On the other hand, Goldman's Chief US Economist, Jan Hatzius believes that the current proposed $700 billion pool should be sufficiently large to buy most of the mortgage securities that the private sector may need to sell before financial institutions can start recapitalizing their balance sheets and lending more freely again.  Latest update as I am typing this: As reported by the Wall Street Journal, the $700 billion bailout bill is now gaining momentum in Congress.  Key lawmakers expect to finalize details of the plan by Thursday morning, ahead of a summit meeting in the afternoon in the White House between President Bush and both the Republican and the Democratic Presidential nominees.  The passing of this bill is now sorely needed, as GE has just cut its earnings guidance and suspended its stock buyback program early this morning.

I am feeling a little bit under the weather today so today's mid-week commentary will be relatively brief.  As I discussed in last weekend's commentary, market valuations tend to be a horrible timing indicator, at least in the short-run anyway.  What I did not mention, however, was the valuations tend to work much better in calling bottoms rather than tops.  With that said, let us take a look at the latest readings of the Barnes Index.  As I stated in previous commentaries, we have been utilizing the Barnes Index (please see our March 30, 2006 commentary for a description) as a measure of relative valuation between the two most important asset classes with money managers and investors today – that of equities and bonds.  Following is the chart courtesy of plotting the weekly values of the Barnes Index vs. the NYSE Composite from January 1970 to the present:

The Barnes Index worked beautifully in calling a significant top last year, when the Barnes Index surpassed the 70 level on several occasions.  Since then, however, the Barnes Index has declined to 40-year lows...

As mentioned in the above chart and in our past commentaries, the Barnes Index was one of the indicators that we relied on in calling for a significant top in the S&P 500 and in the global stock markets earlier last year – when the Barnes Index surpassed the 70 level on several occasions.  More importantly, the Barnes Index declined to a reading of -33.60 as of Wednesday evening – which is at least a 40-year low.  In other words, stocks are now at its most undervalued level relative to US Treasuries for at least the last 40 years.

In addition, the valuation factor of the entire universe of stocks (over 2,000) covered by the competent analysts at Morningstar just declined to a multi-year low of 0.80 last Wednesday (a value of 1.00 is assigned to a particular stock if it hits Morningstar's definition of “fair value”), and is currently still sitting at a near historically oversold reading of 0.82.  The last time Morningstar's valuation factor hit such an oversold level was early October 2002, just as the US stock market was coming out of its last cyclical bear market (as shown in the following chart, courtesy of Morningstar). 

Market Valuation Graph

Again, while the above chart isn't a perfect timing indicator, what it does show is that if one has a long-term horizon, then buying US stocks at current levels will eventually turn out to be a great decision.  As long as the $700 billion bailout is passed, and given the amount of capitulation that we have been witnessing over the last couple of weeks, the market most probably made a tradable/sustainable bottom last Thursday morning.

Finally, even the Chinese stock market – which has been one the fastest growing in history – is now trading at a valuation that is now consistent with a good buying opportunity.  As can be seen in the following chart (courtesy of Goldman Sachs), the 12-month forward P/E of the MSCI China index is now trading at near one standard deviation below its historical average.  The severe liquidation of Chinese shares (and its resultant undervaluation) over the last 12 months suggests that the global liquidation of equities has come or is nearing an end:

MXCN forward P/E

Signing off,

Henry To, CFA

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