14 November 2011 at 15:41 GMT
No more interpretation; cold data is on the menu
We have spent countless hours commenting on Italy, Greece, Portugal, Spain, the EFSF, Merkel, Sarkozy, Berlusconi, Papandreou, the Eurozone debt crisis, bond yields, China's crash landing and the overall slowdown in the global economy. This weekly commentary is not about the endless negative buzz humming out of financial blogs and media. It is about numbers - what a blast, right?
The white noise is everywhere and most commentators and strategists are out voting for sour markets and a faltering economy. We take steps to look at the global stock market from a pure quantitative approach - no feelings, and no politics.
Global stocks are as cheap as in 2003
We take four financial time series on the MSCI World Index; total debt to equity, dividend yield, return on assets and P/EBITDA. We then standardise the time series and combine them equally into a composition Z-score which is the blue in the chart below.
So what can we conclude on global stocks from this no-emotion data? Well global companies are running at a very low leverage compared to the entire period since 1995; a low leverage can be a very powerful driver of future returns when the economy gets going and companies ramp up leverage because it magnifies return on invested capital. The dividend yield of 2.8 percent is also historically high and the P/EBITDA of 5.7 is also low for the period. Only return on assets are weighing on cheapness, as our model penalises high return on assets because a high ROA ratio can be interpreted as we are approaching the end phase of a business cycle. Based on our Z-score global stocks are indeed cheap - in fact as cheap as in 2003!
Cyclical adjusted price earning below historical average
Adding further to the cheap stock argument is a chart of the cyclical adjusted price earning (CAPE) for the S&P 500 Index since 1961; we define CAPE as current price over the exponential average of the last seven years' earnings per share (thus putting a higher weight on recent data). The chart clearly shows that U.S. stocks are not expensive and in fact very reasonably priced.
Data points to cheap stock, why don't investors buy?
Fundamentals point to cheap stocks but investors are still not going all in. Obviously investors are sensible as these markets are not traded on fundamentals, but headlines and political comments making it very difficult to get a firm direction in stocks.
Despite the compelling evidence of cheap stocks based on fundamentals our common sense to investing says that the most sensible way to play this stock market is to be neutral due to the lack of direction and tail-risk to future economic growth.