The South African Index Investor Newsletter

The South African Index Investor Newsletter

www.indexinvestor.co.za

January 2010

Measuring Investors’ Confidence

Daniel R Wessels

Business and consumer confidence indices are well-known leading indicators used by business leaders and decision-makers to gauge the direction of supply and demand activities in the economy. The more confident consumers and businesses are about the immediate future, the more likely consumers will be spending and businesses expanding their operations; i.e. leading to economic growth. Similarly, if investors on the aggregate are positive about market returns in the near-term they will be net buyers of the market and expose their portfolios to risky assets, i.e. shares. But is it possible to measure investors’ confidence about market returns? Is it a reliable measure or does it have any predictability value?

Measuring investors’ confidence is much more complicated to ascertain than consumer confidence – for example, the propensity of consumers to buy luxury items and vehicles – since the judgments people make about the share market are multi-dimensional and influenced by a number of complex motivations. For example, people who are interested in the stock market often view themselves as “playing a game” against other share market investors, trying to guess when shares will do well before others do, so that they can profit from this knowledge. Furthermore, their observations and conclusions may be influenced by the many divergent business reports that appear in the media.

Then again, investor confidence is only one determinant of share prices. Fundamental factors (companies’ earnings reports); legal, tax-related, demographic, technological, international, and psychological factors all play a role.

But if investor confidence is such a complex construct, is it at all possible to measure it? Researchers at Yale University in the USA (The International Centre for Finance) believe it can be measured, but the measurement must reflect its multi-dimensional character. For this reason their confidence index is not expressed as one figure only, but a collection of indices. Furthermore, these indices of investor confidence do not all move in the same direction through time, thus a simple average of the different indices combined would be meaningless.

Locally, Sanlam Investment Management (SIM) adopted Yale’s methodology and since 2007 has compiled a South African Investor Confidence Index. It is conducted on a monthly basis among a group of 80 to 120 investment professionals, which include economists, portfolio managers and financial planners operating in the institutional and retail investment segments. Respondents need to answer 4 questions only by indicating in what direction and by what percentage they think the market will change. These questions and an explanation of how the index is calculated with the results from the latest poll (January 2010) are discussed below:

One-Year Confidence Index:

Question: How much of a change in percentage terms do you expect in the JSE All-share Index during the following periods: one month, the next three months, the next six months and the next year?

The index is calculated as the number of respondents giving a number strictly greater than zero. The index therefore reflects the percentage of the sample that expects the JSE All-Share Index to end positive over the next 1, 3, 6 and 12 months.

Buy-on-Dips Confidence Index:

Question: If the All-Share were to drop by 3% tomorrow, what would you think the All-Share would do the day after tomorrow?

Three options are available namely Increase (%), Decrease (%) or stay the same. The Buy-on Dips Index is the number of respondents that choose an increase as a percentage of the total number of respondents. The index therefore shows the percentage of the respondents expecting a rebound the next day should the market drop by 3% in one day.

Crash Confidence Index:

Question: What do you think is the possibility of a catastrophic market crash occurring during the next six months?

An answer of between 0% and 100% may be given, with 0% meaning it will not happen and 100% it is sure to happen. The index is the percentage of respondents who think that the probability is less than 10%. Therefore shows the percentage of respondents who attach little probability to a stock market crash in the next 6 months.

Valuation Confidence Index

Question: Stock prices in South Africa, when compared with measures of true fundamental value, are too low, too high, or just right?

The valuation index is the number of respondents who choose too low or just right as a percentage of the total number of respondents. It therefore reflects the number of respondents who think that the market is not too high.

From the latest SIM Investor Confidence Index report (January 2010):

“The January survey of the Sanlam Investment Management (SIM) Investor Confidence Indices revealed an overall continued deterioration in confidence among local equity investors. Confidence deteriorated in each of the attributes measured – something that happens very rarely. The valuation confidence has moved down the most over the last year and continues to make new all time lows. This is consistent with the continued strong rise in equity markets experienced since March last year, as a growing concern about valuation would be a very rational response to an equity market that continues to rise at a rate in excess of the trend return expected from equities. At this stage 52% of respondents consider the market to be too expensive, while only 2% think it is too cheap.

The concerns regarding valuation continue to be even higher among the institutional investors, with two thirds of this group viewing the market as too expensive and none thinking that it is too cheap. There have been only two previous incidences where we observed such high levels of consensus amongst institutional investors, October 2008 and February 2009. During both these occasions near 70% of institutional investors viewed the market as being too cheap. In hindsight their collective sentiment turned out to be correct on those occasions, as strong equity returns followed the turning points in equities that coincided with these peaks in valuation optimism.

In line with the increased valuation concern, the 12 month return expectation continues to decline. Investors now expect the market to close one year out at a level just 5% above. Even after adding the dividends one would receive, it would provide a very low real total return (near zero in the case of the institutional investors). Contrary to this decline in the 12 month outlook, expected returns in the shorter term, one month to six months, actually increased. These movements represent a strong improvement in the short term concerns investors previously had and the short term expectations are now more consistent with the 12 month view. So despite the fact that investors are concerned about valuation, they do not foresee a short term catalyst to start a market correction, but rather see the market giving slow, below trend returns for a while. However, the slow returns foreseen do not preclude the risk of a correction and the survey actually showed an increase in the perceived risk of a market crash. The percentage of respondents deeming the probability of a market crash to be higher than 10%, jumped from 37% to 53%, with the average probability of a crash rising from 15.6% to 19.9%.”

Thus, the huge surge in market returns we have experienced during the past 9-12 months (around 50% gains since the lows of March 2009) are making investors more cautious about the perceived value and returns that the market will offer in the near term. Let us review why professional investors are concerned about market valuations today.

The primary and only driver of the recent surge in equity prices was the re-rating of the market. We have seen that the stock market’s price/earnings multiple increased from a factor of 8 to 17 during this period; basically reflecting investors’ sentiment that the synchronised global monetary aid packages will stabilise financial systems and a rapid economic recovery, especially led by China, will follow. The current multiple of 16 to 17 is well above the long-term average of 14.4 (since 1995). Therefore, it is not surprising that professional investors are getting concerned about valuation levels.

At the same time companies’ earnings growth numbers retracted severely in response to the global economic recession. At the moment earnings growth is on a 30% decline year-on-year. Surely this trend, as always, will reverse; there is sufficient evidence that consumer and business confidence levels are on the rise again, but the key question remains how rapid this recovery in companies’ profits will materialise; i.e. is the market judgement at the moment fair or overly optimistic.

Let us consider two possible scenarios. First, if earnings growth is only moderate in the next 12 months (5-15% growth) we are most likely to have very dull and even negative market returns; that is if the market P/E rating will remain more or less at a 15 multiple (long-term average). The second scenario assumes an earnings growth of between 20-30% and with the P/E multiple again more or less stable at a multiple of 15, a fairly decent to strong market performance (10-20% return) can be expected in the next twelve months. Which scenario is most likely?

The general consensus about market return over the next year is somewhere between 5 and 10 percent. I am certainly no prophet (of doom or hope) but knowing the nature of the beast, I will be surprised if market returns are just that. One, I think that resources companies will turn out better than expected profits, especially since commodity prices have recovered strongly and two, profits, especially from certain cyclicals will grow from a low, depressed base. Hence, I believe scenario 2 is more likely. But then again, it remains a speculative bet which way the market will be heading over the next year. The “sure money”, like it was this time last year, is off the table and the equity markets will once again prove it is not for the faint-hearted, especially if you are concerned about short-term investment periods.