Volatility. Investment professionals always go on about volatility, especially when they are not sure what direction markets are going to go. But this is ridiculous. – think-tank by Chris Freund.
Five percent intra day swings in the All Share Index is enough to cause anyone to reach for the Valium. But the real problem is, that after four years of wonderful equity returns, markets have opened 2008 in particularly violent fashion with equities astonishingly quickly down 15%.
Basically the entire 2007 equity return has been wiped out even before we have comfortably settled in after the holidays. So what to do now? Too late to panic, or get out now before you lose more money?
Predicting the future is always difficult, but particularly so in the very short term. What we do know is, that markets are in panic mode and that fear is at an extreme. From a contrarian perspective this is usually a buying signal, something along the lines of keeping your head, while others all around are losing theirs. However, aside from looking to benefit from any short term rally from an extreme oversold position, the more important question is to consider whether this is the start of a multi-year bear market or merely a particularly upsetting setback. At times like this we are invited to step back, take a deep breath and re-examine the fundamental drivers of equity markets. The three major drivers are expected earnings growth, interest rates and valuation. In this regard I guess, the first real point is that the crisis surrounding global banking shares is far more serious than initially suspected by the markets. The subprime issue has morphed into other fearsome anachronisms, all of which imply that the US housing market setback is far from over.
Consequently US earnings growth is rapidly being revised downwards, with the resulting knock-on effect to global growth. But this issue then extends to the great decoupling debate, or to what extent emerging markets, including China, will avoid any economic slowdown in the developed world economies. Whatever the outcome, the bad news for markets is that earnings are being revised downwards. The US is likely to go into a recession, but our view is that global economic growth will only slow, not stop. If we then consider the outlook for interest rates, most recently the US Fed has been in aggressive cutting mode as they fear this pending economic slowdown and lubricate the wheels of credit extension.
Normally, slowing growth would automatically result in the soothing effects of lower rates, but food and oil prices are currently confusing the issue. As a result the headline inflation numbers look bleak, but the core underlying numbers do not look especially threatening. On balance, the inflation outlook does not look bad enough to stay the hand of central bankers as they move to stop the economic rot, thus offsetting the weaker earnings outlook. The market should be able to draw comfort from lower rates. This then leaves us finally to examine value. As mentioned above, in the short term anything can happen but value is important, especially as it impacts longer term returns. In this regard we can relax a little, in that global equity markets should not be considered as expensive.
In fact, equity markets are cheaper than they have been for many years, and from a valuation perspective this is not a repeat of the 2001 bear market. Some astute commentators consider that the developed markets are already priced for or anticipating a 20% fall in earnings. There are some obvious exceptions, including the Chinese and Indian stock markets, but most of the other emerging markets are reasonably priced. On balance then, no need to panic out of the markets now. Slowing earnings should be offset by lower interest rates and respectable valuations. The ingredients just do not look right for a long drawn out bear market similar to Japan in the 1990’s.
Bringing the issue closer to home, this point is even more powerful. It would have been great not to lose any money and to have switched it all into cash a month ago, but that is water under the bridge. Right now, we have the opportunity to buy very cheaply high quality SA companies, with good management teams and long respectable track records. Many of these SA companies are on forward PE’s of 8 or 9 times, and dividend yields of 5% or so. Growth will slow, but it is cyclical and will recover in time. Now, is the time to keep your head and to be buying, not selling. All one needs is time, as night follows day this crisis will recede, credit markets will reopen, and the panic will subside.
In the short term markets could go lower, but if you are saving for your retirement where you should have time on your side or have more than a twelve month horizon, then buying shares at these prices is very likely to pay off handsomely. A last point from a sectoral perspective is, that industrial commodity prices could well fall further in the coming months, so we are less sanguine about the outlook for resource shares (excluding gold and platinum) and consider that SA banks will offer better returns in the medium term. (Investec Asset Management)
Chris Freund is a portfolio manager at Investec Asset Management