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. Last Updated: 07/27/2016

Bulls Alive and Kicking

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If bull markets classically climb a "wall of worry," then surely the RTS must be fitted out with ropes and pitons! Repeatedly this year we have been warned that the Russian bull was to be slaughtered -- by reform fatigue and political volatility, by the Yukos scandal or the "summer doldrums," even by the dread "September effect." All proved to be nothing more than the hobgoblins of underemployed minds.

In a recent opinion piece on these pages, James Fenkner likened the current RTS rally to the Nasdaq bubble. The comparison seems patently absurd: Although the notorious tech bubble was also liquidity-fueled, it was built upon the "new economic paradigm" -- valuation metrics developed ad hoc when the old ones became hopelessly stretched. The Russian boom is driven by old-fashioned values: retained earnings, minerals in the ground, dividend yields and hugely undervalued hard assets. Tellingly, and unlike the situation preceding the 1998 meltdown, the market has surged almost entirely on local buying -- increasingly wealthy Russians investing in their own economy.

Fenkner tendentiously suggests that the local analyst community has engaged in a self-serving game of hype-the-market -- again, analogous to that seen in the later phases of the U.S. Internet bubble. This is nonsense. Most senior analysts in Moscow lived through the August crisis and at least until recently, research by the local houses has ranged from the fairly conservative to the chronically bearish. Last year, one well-respected Russian oil analyst -- systematically pessimistic about oil in general and the Russian market in particular -- summarized his conference presentation with a warning about the four most expensive words in finance: "This time it's different." Well, this time it HAS been different.

Though the Russian market has no dearth of problems (e.g. regulation, transparency, liquidity), conflicted analysis is simply not one of them. Given that there has been precisely one large IPO over the past several years, the fact that Moscow analysts are paid from the profits of their trading desks, not from corporate finance mandates, should be intuitively obvious. While many local houses make most of their money on "special situations" -- buy-backs, takeovers, etc. -- these are confidential. God help the analyst who refers to any of them in public! Indeed from the broker's standpoint, markets are symmetric: Frightening clients into selling into rallies can generate huge trading profits.

Given stagnant G-7 economies and a resurgent Asia, global emerging markets are back in fashion -- especially the commodity exporters. This is by no means confined to Russia. Markets from Brazil to India, Argentina to Thailand are rocketing; indeed in September, Eastern European equity markets marginally outperformed Moscow.

Several purported "misconceptions" were listed:

"The economy is growing, therefore the equity market must rise." This does not necessarily follow, but by increasing the general level of liquidity as well as demand for those goods and services that are represented in the RTS, roaring GDP growth has allowed a sustainable revaluation of the market -- unlike the growth-free bubbles seen in Russia in 1997 ... or on Wall Street today.

"High oil futures do not guarantee a high future oil price." Indeed they don't -- they do, however, constitute the single best predictor for an otherwise notoriously difficult price to forecast. I have long argued against the doomsday scenarios of oil analysts -- local and global. In fact, these have proved almost comically inaccurate. Even the futures curve, in continual backwardation, has proved far too conservative. The "sophomoric error" is actually to compare current nominal prices with their 30-year average, without accounting for inflation.

"Russian oil reserves are cheap." If they aren't, then why is Moscow swarming with international oil men desperate to buy them? Far from having reached anything remotely approaching the levels of their global peers, a barrel of oil reserves worth $1 on the balance sheet of LUKoil is worth $11 on the books of "geographically diversified" Exxon Mobil (think Nigeria, think Colombia). Admittedly, they are not strictly comparable: Russian oil companies are hobbled with low domestic prices, but an 11-fold discount seems overly conservative.

Similarly, the assertion that BP halved TNK's declared reserves because it thought them overstated suggests ignorance of SEC regulations; this adjustment is purely a technicality based on the "one-offset rule," imposed in the aftermath of U.S. small-cap oil frauds. Obviously BP thoroughly audited TNK reserves before its purchase. Regarding depreciation, the GAAP/IAS accounts available for all oil majors calculate it to international standards. Furthermore, most Russian oil assets have already been depreciated, and there is a good 30 years of potential production from current fields with only maintenance.

Russian price/earnings, or P/E, ratios remain fundamentally cheap -- greatly so compared to G-7 markets, substantially even to their emerging market peers. The energy sector is the exception, but to value UES and the energos on the basis of P/Es is patently absurd: All are to be broken up and restructured over the next 18 months. Russian energy should be priced in terms of replacement values and price per megawatt capacity.

If there is one certainty, it is that, like every other market, at some point the RTS will correct. The question is when, from what level and, crucially, by how much. To sell now, with Russian and Western players competing for a limited supply of assets, in anticipation of a 10 percent sell-off from levels 25 percent above the present, is not intuitively obvious.

For those of us who survived the long nuclear winter that followed the August '98 collapse, preaching in the desert when all the world believed the term "Russian finance" to be a misnomer, the recovery of the Russian markets has been a marvelous vindication of our faith. The current pace of the rally indeed provokes vertigo; yet, when the inevitable correction does occur, it will likely prove nothing more than a healthy bout of profit taking, preliminary to the further rerating of Russian financial markets.

Eric Kraus, chief strategist and head of equities for Sovlink Securities, contributed this comment to The Moscow Times. His full views can be found at: www.sovlink.ru