MOST of those who took finance courses would remember the Efficient Market Hypothesis (EMH). It asserts that financial markets are 'informationally efficient' - that is, prices of traded assets such as stocks, bonds and property already reflect all known information. According to the EMH - for which a Nobel Prize in economics was awarded - it is not possible to consistently outperform the market by using any information the market already knows, except through luck. Recent movements in markets have reaffirmed my cynicism of EMH. Here are a few recent examples:
Bear Sterns
This company's stock was trading around US$82 (a market value of US$10 billion) 30 days before becoming almost worthless recently. How can US$10 billion be destroyed so quickly if the market was efficient? Whether by rumour or manipulation, Bear became insolvent within a few days as most lenders suddenly refused to lend to it any more - something that had never happened before in the past 90 years. Rumour and misperception - not true information about the company, as required by EMH - created their own reality of insolvency very quickly as credit lines were withdrawn in unison.
Inflation
The commodity and bond markets are saying different things about inflation. Looking at the soaring prices of commodities, one could assume we will be having persistently high inflation over the next few years. However, the bond market appears to signal that the jump in inflation will be transient. 10-year bond yields in the US, Europe, Japan and Singapore have stayed low despite recent inflation numbers. If the market believed that inflation would be persistently high, yields would have soared. Indeed, inflation-protected securities are signalling that inflation will stay around 2-2.5 per cent globally over the next 10 years.
The current bout of high inflation is concentrated in energy (especially crude oil) and food. To diversify from petroleum, the US doled out big subsidies for farmers to produce ethanol from corn. Acreage that was previously used for food and feed production was converted to ethanol production - creating a food supply squeeze. We are sceptical about the demand story - that Indians and Chinese are gorging more. Indeed, the high prices of energy and food will be their own cure eventually because it is now very profitable to invest in supplying food and energy.
I would be careful on commodities in general as the parabolic rise in prices is difficult to justify given the level of sustainable demand. A good example is gold. According to the World Gold Council, physical demand for gold in 2007 versus 2006 rose only 4 per cent but prices soared 50 per cent. The rationale that gold is a hedge against inflation and the falling US dollar may be true, but the price move has been exaggerated. Indeed, the biggest component of demand is for jewellery, which is about 70 per cent of total demand, and this hardly grew in 2007. However, gold exchange-traded funds (ETFs) - which represent speculative demand, as there is no yield on this instrument - now account for 7 per cent of total gold demand, up from nothing a few years ago. It should be noted that global physical demand for gold at 3500 tonnes translates into a small market of only US$110 billion per annum or about three days' trading turnover at the NYSE, or three months at the Singapore Exchange. It is, therefore, fairly easy for a number of large speculative funds to drive prices higher quickly.
Valuations
The annualised 10-year rate of return for the MSCI World Index, including after-tax dividends re-invested, has fallen off the cliff, to merely 4.59 per cent at March 27, as price-earnings ratios compressed. This is an all-time low for the MSCI World despite the sound economic fundamentals worldwide ex-US.
Returns on global equities theoretically should track dividend yields plus nominal world GDP growth. This has been more than 9 per cent in the past 10 years. Indeed, the average annualised return of the MSCI World Index for the past 38 years from Dec 31, 1969, to Dec 31, 2007, has been 9.91 per cent.
Why have valuations worldwide fallen so low - and in unison - despite the sound economic fundamentals? Fear is one possible answer. The other more likely primary cause is the sudden disappearance of liquidity in many areas of the debt markets. Investors who need to raise cash for their portfolios for one reason or another have been forced to sell what they can and not what they want to. Unfortunately, global equity markets have stayed liquid and, therefore, have borne the brunt of the need to raise cash. I believe that reversion to the mean will eventually occur, but the timing is uncertain. A return of merely 4.59 per cent corresponds to world economic growth of about zero to one per cent in the foreseeable future. Unless, one believes the world economy is about to fall into a permanent state of near-recession, mean reversion must eventually occur. Otherwise, equity valuations will continue to compress until they become giveaways - which would be illogical. Should returns revert back to the mean, the implication is a rise of more than 40 per cent in global equity markets.
I believe the catalyst for this reversion to the mean is the sharp build-up in liquidity in the financial system. Since the big 1.25 per cent cut in US Fed rates in mid-January, US money supply measure M2 has taken off like a rocket. M2 is now considerably in excess of US nominal GDP growth.
Meanwhile, money market funds have grown by about US$1 trillion in the past 12 months. Once the log-jam in financial markets is cleared, this wall of excess liquidity must find its way downstream into the capital markets and the real economy.
Joseph Chong is CEO at financial adviser New Independent. He welcomes feedback at josephchong@ni.com.sg. This article is for information only. Readers should seek independent advice before making any investment decisions.
