Regular readers will have noticed that I have been slightly more bullish (or, should I say, less bearish) since the end of last year. In particular, they will have noticed that while I am as anti - emerging markets as ever, I am gradually getting keener on the US, the UK and Europe.
This is partly because the huge problems facing us are now well understood; and a problem recognised is mostly a problem on the way to being solved. But more than that, it is because I have been getting the sense that developed markets as a whole offer more value than they did.
So I was glad this week to have the chance to talk to two of the gurus of value investing in the UK: Russell Napier of CLSA, and Andrew Smithers. Both were in Edinburgh to speak at a seminar to celebrate the 125th anniversary of the launch of the Scottish Investment Trust.
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What are their views? Napier, I'm sorry to tell you, damns the idea of 'value' with very faint praise. He uses the cyclically adjusted price/earnings ratio (Cape), which takes ten years of earnings into account, because it, along with the Q Ratio, is just about the only valuation measure with any history of predicting long-term returns.
The US market Cape ratio is 22 times. It's been more expensive than that, but 22 times is near the top of the range. The average over the period 1881 to 2012 and the level that suggests real returns of 6% over the following decade is more like 15 times.
Buy at 22 times, says Napier, and you can expect to make only 0-4% a year over the next decade.
Worse, Cape isn't much good at telling you what will happen in the short term, so there is every chance that, on the way to making very little, you might lose a lot several times over.
What you really want to do is to wait and buy when the market hits or falls below a Cape ratio of ten times. Investors who have bought there (in 1929, in 1937 and in 1977) saw real returns of between 11 and 23% in the following ten years.
So Napier is waiting on the basis that, while holding cash is frustrating, it is better than being in a fast-falling equity market.
What might make the market fall to a more attractive valuation in the short to medium term?
For this, I turn to Smithers. According to his analysis which I think is generally better than everyone else's one very valuable piece of information has been overlooked by almost everyone. It is this: in the US, companies have become the only net buyers of shares.
Data from the Federal Reserve shows purchases by US institutions and households declining from 1997 onwards, with the slack picked up by a sharp rise in corporate buying (this includes both share buybacks and purchases as a result of mergers and acquisitions).
In fact, if you take corporate share purchases and chart them against the performance of the stock market as whole since 2001, you will see a very strong correlation.
His conclusion, therefore, is that the performance of the market is very much driven by companies buying shares their own and other people's. And what makes companies buy shares? Cash.
Smithers has another chart showing that the more cash companies have, the more shares they buy. They have cash; they buy shares and the market goes up.
In the short term, then, the stock market is only protected for as long as corporate cash flow stays strong.
Is that a bet you want to take? Smithers doesn't. He points out that, as the US deficit falls (which it surely will after the election), corporate cash flows are bound to fall off.
But the US deficit aside, one of the main reasons why cash flows have been so super strong in the past few years has been because large corporates have been delaying capital expenditure.
They can't do this forever. If you delay spending for too long, your stuff stops working, which begins to threaten your productivity and the sustainability of your profits. Add it all up, and Smithers thinks it makes sense to wait, too. He reckons the US market is around 40% overvalued.
That all sounds like bad news. But there is some good news, as well. First, if you invest in the US you should at least reap the rewards of the strengthening dollar. Second, valuations are falling in Europe: in the UK, the Cape ratio is a mere 13 times which is below average! What's more, some of Europe is beginning to look like it offers value: France is on 13.6 times, Germany on 17 times and Italy on 8.6 times all levels that suggest you might actually be able to look back in a decade's time and say you made money.
But before you rush to buy, a note of caution: when you use average earnings from the past ten years to value a market, you are assuming that those earnings will be repeated in the next ten years. That, as Napier quite rightly says, is not exactly a given with, say, an Irish bank. When you buy, buy with caution.
This article was first published in the Financial Times.
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