When I studied economics at university, I learnt various methods that could be used to value shares and thus markets. PE and PEG ratios, growth, cash flow and NAV were commonly used to extract the ‘true’ value of a company. For most of my career, these techniques have served me well. However recently it has been harder to determine value due to two important factors.
Firstly stocks have become highly correlated with the market. What I mean by this is that when the market goes higher or lower, almost all stocks tend to move in the same direction irrespective of their own fundamentals. Though this is not a new phenomenon, it has become much more pronounced in recent times. A possible reason for this is the increase in high frequency traders. These traders often buy and sell massive amounts of assets in a very short period of time. Thus the volume of their trade easily swamps that of longer term investors. Another possible cause is the emergence of Index ETFs and other similar instruments, such as the Satrix40, ALSI or Spider. If I think that the market is heading higher and buy a Satrix40, then I am effectively buying all the stocks on the Top 40, so it is logical that this would tend to cause stocks to move together.
The second factor is the increased involvement of governments and central banks in the market. Ever since the financial crisis of 2008 and some argue even before, policymakers have attempted to manipulate the markets by various means. Markets have become increasing wise to this and now we are in a situation where announcements from the Fed and ECB are actually much more important to the market than the latest round of trading statements.
To give you some idea just how significant policy has become, next week the US will release its Payroll numbers. Some argue that this is the most important economic number in the world. If it comes in worse than expected, there is a reasonable chance that global markets could rise. This is due to the fact that bad economic numbers increase the chances of more Quantitative Easing from the US central bank. Thus the actual strength of the world’s largest economy mattered less than the possible reaction of its central bank.
The situation in Europe is even worse as governments grapple with a massive sovereign debt crisis. The very nature of the problem requires a political solution. Thus statements by politicians and central bank officials take on increased importance. In a recent example, a few words by Mario Draghi, head of the European Central Bank, caused global markets to rally. Our own JSE moved up several percent, and set new all time highs.
In such an environment fundamental analysis means very little in the short term. In the longer term, however, value will always win out. A strong company will eventually be more valuable than a weak one. The key is to spot the value and having patience.