Is the U.S. Stock Market Overvalued?

In March 2009, the S&P 500 bottomed at 666. Today it’s about 2,500, that’s a 275 percent increase over 8 years. This (U.S. stocks) bull run has been strong and long lasting. A Trump victory has given credence to the fact that there is “more room to run”. But is that true?

The total market cap (TMC) to GNP ratio, or the Buffett indicator, is “probably the best simple measure where valuations stand at any given moment”. The chart below is the current ratio of total market over GDP (proxy for GNP) and its historical range.

(Source: AdvisorPerspectives.com)

The ratio cannot be used to compare the valuation levels of different nations. Some are driven by large public listed companies, others by state-owned companies. Then there are differences in reporting, accounting rules, regulations and tax laws. Further, some suffer from low equity ownership. For example, India has only 4% of adult population who own stocks compared to 52% in the U.S.

Country	GDP ($Trillion)	Total Market/GDP Ratio (%)	Historical Min. (%)	Historical Max. (%)	Years of Data
USA	19.25	134.9	35	149	47
China	12.43	48	41	662	27
Japan	4.55	150	56	361	33
Germany	3.69	53	13	58	27
France	2.65	92	52	182	27
UK	2.6	124	47	201	45
India	2.46	68	40	158	20
Italy	2.16	15	10	45	17
Brazil	1.97	48	26	106	20
Canada	1.72	121	78	190	27

(Source: https://www.gurufocus.com)

That said, the U.S. current market cap/GDP ratio of over 135 per cent could be problematic, if you subscribe to Buffett’s mantra. As he (Buffett) says, “for investors to gain wealth... the percentage relationship line... must keep going up and up”. And if it gets too high, Buffett says you’re “playing with fire”.

The cyclical-adjusted-price-to-earnings (CAPE) ratio of a stock is another standard metric used to evaluate if a market is overvalued or otherwise. This metric was developed by Robert Shiller of Yale and popularised during the Dotcom Bubble. It’s a variant of the typical price-to-earnings (P/E) ratio of stocks.

When the CAPE ratio is high, it’s usually wise to reduce equity exposure.

CAPE Ratio S&P 500

(Source: http://www.multpl.com/shiller-pe/)

The CAPE and Market Cap/GDP ratio generally correlate closely.

So is the U.S. market overvalued?

Robert Shiller suggests long-term investors to cut back on their equity holdings. At this level, he suggests that “the expected return for stocks might be negative, but only slightly so”. Shiller adds, “... it’s quite reasonable to have an investment in U.S. stocks as part of a diversified portfolio... but don’t go overboard on it”.

How Do We Measure Income Inequality?

The Gini coefficient is a commonly used measure of income inequality. It condenses entire income distribution for countries into a single number between 0 and 1 – the higher the number, the greater the degree of income inequality.

The level of inequality differs widely around the world. Usually, emerging economies are more unequal than rich ones. Scandinavian countries have the lowest income disparities, with a Gini coefficient of around 0.26. The most unequal, like South Africa, registers around 0.67. The U.K. has a figure of around 0.36 while the U.S. is around 0.48.

Malaysia’s Gini coefficient according to the Economic Planning Unit, has improved to an all-time low of 0.40 in 2014.

This contradicts United Nations Human Development report that suggests the richest 10% control over 38% of income compared to poorest 10% who only have 1.7%. The World Bank puts Malaysia’s 2014 Gini coefficient at 0.421, higher than the Government’s calculation. Data discrepancies aside, how do we address inequalities?

• First, by reducing wage gaps, where the CEO of a major public listed company earns RM3.0 million (or more) and a fresh graduate earns only RM48,000 per annum;
• Second, improving social assistance for the poor so as to generate new income streams or create opportunities for re-education or upskilling; and
• Third, effective cash transfers or credit vouchers that meet daily needs of food, transport and shelter. Social and para-social organisations have long been involved in easing the burden of the poor.

Affordable quality education, fair wages and opportunities for entrepreneurship may help the next generation of Malaysians to reduce income disparities faced currently.

For more information about Gini coefficient, please visit http://www.mpcap.com.my/ or contact info@mpcap.com.my.

Project Ranking Methodology for Public Infrastructure Project

Global estimates of infrastructure investments required to support economic growth and human development lie in the range of US$65-70 trillion by 2030 (Read more here), while the estimated pool of available funds is limited to approximately US$45 trillion (Read more here).

Conventional project finance ranking methodology using Net Present Value (NPV), Internal Rate of Return (IRR) and/ or Payback Period (PBP) are straight forward and common among corporate practitioners as these methodologies seek to maximize shareholder’s wealth.

Public infrastructure projects, on the other hand, require more than maximizing shareholder’s wealth.  Other factors such as social and economic impact are equally important for decision making.  Furthermore, they often show an opposite impact as compared to financial results.

The World Bank has proposed an Infrastructure Prioritization Framework (IPF) in 2016 (Read more here).  It has a multi-criteria decision support tool that considers project outcomes along two dimensions, social-environmental and financial-economic.  Illustration below shows the summary and outcome of the IPF.

The core idea of the IPF is the statistical process, which consists of data Z-score standardization, normalization, and then using Principal Component Analysis (PCA) method to assign weightage to each component to form the index.  PCA is an advanced statistical method recommended by Organisation for Economic Co-operation and Development (OECD) to assign weightage for Index construction (Read more here).

The above framework is useful to examine HSR, ECRL, MRT and other similar transport projects that will have an impact on the economy.

Example of Transport-Projects Ranked.

Based on the above, project 2 is a great project although its IRR is not high while projects 1 and 5 are to be rejected under this methodology.  Whilst projects 3 and 4 are deemed acceptable on the FEI and SEI indices.

For more information about project ranking methodology, please visit http://www.mpcap.com.my/ or contact info@mpcap.com.my.   

Is It Always NPV vs IRR?

                                         Picture source: capitalbudgetingtechniques.com

To measure the returns of a project, many use NPV and/or IRR. But which tool is better?

Safe to depend on NPV method for project selection. Generally used by financial analysts in DCF valuations to find present value of free cash flows to firm.

For more information about NPV vs IRR, please visit http://www.mpcap.com.my/ or contact info@mpcap.com.my.

Is There a New Phillips Curve for Malaysia?

The Phillips curve (advanced by A.W. Phillips in 1958) is the inverse relationship between inflation and unemployment – as unemployment decreases, inflation increases.

In this graph, an economy can either experience 3% employment at the cost of 6% inflation, or increase unemployment to 5% to bring down inflation level to 2%.

Two researchers from USM (Chor Foon Tang, Hooi Hooi Lean), concluded in their article in the Malaysian Journal of Economic Studies (Dec 2007) that for the sample period of 1970 to 2005, the trade-off Phillips curve is “alive and well in Malaysia”.

Fumitaka Furuoka (2007) of UMS in “Does the Phillips Curve Really Exist? New Empirical Evidence from Malaysia”, Economics Bulletin, Vol 5, No. 16 pp 1-14, concluded that “there existed the cointegrating relationship – as well as casual relationship between relationship between inflation rate and unemployment rates in Malaysia”.

Nevertheless, the accuracy of the Phillips curve has been questioned by many sane economists. It is probably nothing to do with the curve but the more complex economy we face. Consumer credit at peak levels has flattened consumer spending, causing a low inflation environment (but not deflation), decoupling perhaps unemployment and interest rates. In Malaysia, with a decline in disposable incomes as a result of high household debt levels inflation is tepid at best. In an economy where technology has taken jobs and debt levels impact inflation, there is more than the casual impact of inflation and unemployment. Perhaps, a New Phillips Curve could be established.

For more information about Philips Curve, please visit http://www.mpcap.com.my/ or contact info@mpcap.com.my.

Oil Price Impact on Ringgit Exchange Rate

According to Bloomberg’s report (Read more here), oil-related sources contributed about 41% of Malaysia government revenue in 2009.  This dropped to 13% – 14% in 2016.  As such, crude oil price has an impact on Malaysia’s economy, including the Ringgit exchange rate.

The following graph shows the regression plot of USD/RM vs Brent Crude Oil from July 2005 to July 2017.  It shows that the Ringgit movement was significantly influenced by oil price.  Ringgit strengthened when oil price was high while the Ringgit weakened when oil price was low. 

The scattered dark blue dots are the actual data of USD/RM corresponding to respective Brent Crude Oil price from July 2005 to July 2015 while the scattered red dots are the actual data of USD/RM corresponding to respective Brent Crude Oil price from August 2015 to July 2017.  The light blue curve is the fitted regression line between USD/RM and Brent Crude Oil price (July 2005 – July 2017, R² = 0.74) while the dashed red line is the + one standard deviation plot from the fitted regression line.

It is interesting to observe that before Aug 2015, the Ringgit was stronger and was well predicted by the regression line.  However, since Aug 2015, the Ringgit has weakened by + one standard deviation.

In the World Economic Outlook, April 2017 report, International Monetary Fund (IMF) predicted the oil price to be trading around USD55 per barrel in 2017 – 18 (Read more here).  Based on this, the Ringgit could be forecasted using the above regression analysis.  If all the post-2015 negative issues in Malaysia are resolved, Ringgit could trade around USD/RM 3.80.  Nevertheless, if the negative issues persist, the Ringgit may trade around USD/RM 4.18 as the above graph suggests.

For more information about regression analysis and business forecast, please visit http://www.mpcap.com.my/ or contact info@mpcap.com.my.

  

Factors That Impact Foreign Exchange (Forex) Rates

Forex is a means to understand a country’s relative level of economic health. If you are thinking of sending or receiving money from overseas, you will keep a keen eye on currency exchange rates. This short article suggests the factors that impact Forex.

·       Inflation - changes in inflation impact exchange rate, a lower inflation (or its perception thereof) will see appreciation in the value of its currency.

·       Interest Rates – changes in interest rates affect currency value and Dollar exchange rate. An increase in interest rate causes a country’s currency to appreciate because higher interest rates provide better returns (in a relative sense) thereby attracting more funds into the country.

·     Current Account / Terms of Trade – a deficit in the current account due to higher imports of goods and services compared to export of the same causes depreciation.

Related to current account is the ratio of export prices to import prices, which are the terms of trade. A country’s terms of trade improves, if export prices rise at a greater rate than import prices. Higher revenue means higher demand for the currency and an appreciation of the exchange rate.

·     Government Debt – The level of Government debt owed by the Central Government impacts on exchange rate. If debt levels exceed prudent limits, investors flee the market and bonds (or other assets) are sold and a decrease in exchange rate ensues.

·    Political Stability and Economic Performance – A stable state with good economic performance reflects a country’s currency strength. Less turmoil is obviously more attractive (than discord). It is in the interest of political leaders then to minimise issues and create stable environment for investors.

Steady economic growth will see foreign investors vying for projects in a country. On the other hand, a downward trajectory (or expectation thereof) will weaken the currency as authorities may have to lower interest rates and provide liquidity to the system.

·        Market Makers – the Forex market is a global decentralised or over-the-counter (OTC) market for trading currencies. It is the largest market in the world.

The main participants in this market are the large international banks, central banks, institutional investors, commercial corporations, individuals and currency speculators.

Based on Bank for International Settlements data, global trading in Forex markets averaged USD5.1 trillion per day in April 2016.  In May 2016, the top three currency traders by volume were: Citi (12.9%); JP Morgan (8.8%); and UBS (8.8%).

                                                           

While exchange rates are determined by several factors, which may leave some economists in confusion, investors who have some understanding of currency values and exchange rates play a key role in determining the rate of return on their investments.

For more information about forex impact to your business, please visit http://www.mpcap.com.my/ or contact info@mpcap.com.my.