Even after this week's small stumble, the rise in markets since the second week in March is still nothing less than stunning: the S&P 500 is up 36% since March 9th, the MSCI Europe is up 47%, MSCI Asia Ex-Japan is up 53% and the MSCI Emerging Markets Index is up 55%.
There seem to have been a number of factors behind this:
(1) The explosion in the global money supply. As governments around the world have been embarking on programmes for printing money and/or pump priming, the growth in the global money supply has gone exponential. This can be best illustrated by the following chart from Morgan Stanley's Gerard Minack:
There has clearly been an element of linkage between this and the amount of "excess liquidity" that has even found its way into markets and helped to offset some of the value destruction that drained liquidity from the system in the second half of 2008.
Although Gerard may not agree (he reckons that the change in the chart is simply due to fluctuations in market cap: the actual value of cash has continued to rise in line with historic norms), we give some credence to the fact that holdings in cash and money markets remains at very elevated levels and does have a bearing on markets as and when even a small part begins to be deployed:
(2) Increases in risk appetite: Whether or not sidelined cash is a factor, it is certainly the case that risk appetite has recovered, as fears over systemic shocks to the global financial system and economy have reduced from near panic levels.
Many individuals and money managers have been sitting on large cash holdings as a means of minimising risk and have only belatedly begun to deploy these as fears of getting left behind have outweighed fears of getting caught out by another slump. This is the proverbial "wall of worry". This has been evident in many risk assets: even London property has apparently been seeing a big jump in activity in the last month or so.
In addition, with many fund managers maintaining cash buffers in early Q2 2009 against potential redemptions, as these redemptions have slowed or turned aout to be smaller than expected, the need to maintain such substantial cash reserves has similarly lessened.
(3) Recovering economies: This is where we are most skeptical. It is clear that the rate of decline in economies has slowed: surprise, surprise.
When you start comparing a low figure with a previously low base number, the percentage decline is similarly - low. "Not declining as quickly", is however, a big stretch from real "recovery".
Indications remain that corporate earnings growth is still going to be sluggish for 2009, as we head into the second half: that means that real earnings growth may be pushed into 2010 or, more likely, beyond. With unemployment in the US continuing to nudge upwards, its going to be a while before consumer spending there starts picking up. The same seems to be true elsewhere. If that is the case, then markets, on a short-term basis at least, are looking expensive and have discounted recovery too quickly and too aggressively.
Our view remains that markets are overdue at least a 10-15% correction (India is now down 7.8% in the last 9 days, for instance) as they pause for breath after a head spinning rally.
Once they have come back somewhat, they will obviously provide better value than they do at present.
Markets currently appear to be priced for relatively little disappointment: there still seem to be plenty of weeds amongst all those green shoots....
Yvonne & I were watching an episode on “Oprah” last year (yes, it’s true) in which she featured a revolutionary new website called Kiva (www.kiva.org). My memory was jogged this morning on my drive into work when listening to the BBC World Service. They featured a segment about how Kiva has just started to extend its project to lend to small business owners in the USA (previously Kiva had focused only on developing countries) who are similarly shut out of traditional sources of finance: a real reflection of how the credit crunch is hitting globally.
You can go to Kiva's website and lend, interest-free, to someone across the globe who needs a loan for their business - like raising goats, selling vegetables at market or making bricks.You can choose by project type or region, if you wish. Each loan has a picture of the entrepreneur, a description of their business and how they plan to use the loan so you know exactly how your money is being spent - and you get updates letting you know how the entrepreneur is going.
You can loan as little as $25.00, and pay for it using your credit card.
The best part is, when the entrepreneur pays back their loan you get your money back - and Kiva's loans are managed by microfinance institutions on the ground who have a lot of experience doing this, so you can trust that your money is being handled responsibly. This is therefore not traditional philanthropy: the borrower has a responsibility to pay the loan back, interest free, and you can then re-lend that money to someone else.
What a great idea.
As an example, I just made a small loan to an women’s entrepreneur group named Nasreen Muhammad Jamil Khan Group in Pakistan.They still need another $1,175.00 to complete their loan request of $1,325.00 Help me them off the ground by clicking on the link below to make a loan to Nasreen Muhammad Jamil Khan Group too:
It's finally easy to actually do something about poverty - using Kiva, I know exactly who my money is loaned to and what they're using it for.And most of all, I know that I'm helping them build a sustainable business that will provide income to feed, clothe, house and educate their family long after my loan is paid back.
Join me in changing the world - one loan at a time. I plan to get my children to go through the website and adopt a project too.
John Maynard Keynes was a source of a number of apposite quotes (his final words being "I should have drunk more champagne"...), but one with strong current relevance is the one in the title of this post: "The market can stay irrational for longer than you can stay solvent".
The rally in markets since March 9th has been little short of incredible: the S&P 500 was up 35.8% by the end of May, the MSCI World Index was up 42.5% and the MSCI Emerging Markets Index up a breathtaking 60.7%.
All this at a time when the economic background remains fragile. Granted, we no longer seem to be staring into the economic abyss, and the rate of decline in core economic statistics has slowed, but the prospects for an equally dramatic recovery in economic and corporate prospects looks non-existent. We are heading for a gradual recovery over a long period of time.
On that basis, what could possibly explain the significant disconnect between markets and underlying business conditions?
(1) Massive liquidity injections. The apparent fervour with which central banks have been pursuing "Quantitative Easing" has resulted in massive injections into the financial system. With interest rates having been pushed down as a consequence, the opportunity cost of holding cash has risen at the same time as perceptions of risk have fallen. The natural result has been that excess cash has been encouraged to find its way into the system with a speed that still looks stunning. The implications are, therefore, that the doctrine of quantitative easing has sparked off the inflation of a new bubble in risk assets. (2) Stimulus spending. Whether or not it's from China, the US or anywhere else, governments have embarked on pump priming as a means of taking up excess capacity and on trying to safeguard jobs. Such measures take longer to make their presence felt than quantitative easing but should help to slow the rate of contraction or even to spark a turnaround (exactly what markets have been betting on). (3) "Green shoots". The metaphors on early indicators of a recovery have been flowing thick and fast: whether you're in the "coming up roses" or the "just weeds" camps, there are some signs of a gradual turnaround, even if it's merely a slower rate of decline (mathematically, this would seem inevitable given the sharp falls across a whole host of economic data in the second half of last year). (4) Confidence. Building on the above has been a marked turnaround in confidence. Whilst this could prove to be ethereal, it is certainly the case that both companies and individuals have begun to resume planning for longer term investment decisions, as opposed to just anything that merely supports survival for the next 3 to 6 months. Decision deferral has been replaced by decision making.
An illustration of this last point is that property prices, whether in Singapore or in central London, appear to have recovered some of the ground lost in the panic of Q4 2008, supported by the fact that those banks that are able to do so are beginning to venture back into the old business of lending money (at spreads that would have been unheard of 12 months ago).
So where does all this place us?
For our part, we began to venture back into equity markets in April, but have not embraced the recovery with full conviction. There is still plenty of economic uncertainty and the full ramifications of a severely constrained global consumer have not yet been worked through.
We have, however, built back our equity exposure from zero to about 25%. We have also added other risk assets that we think will also benefit from recovery, but with a lower degree of volatility: this includes corporate bonds, high yield bonds and a small exposure to commodities. We've also been using the current rally to trim out holdings in illiquid investments at significantly better prices than three months ago in favour of investments that have the same characteristics, but are a lot more liquid (that means exiting from some restrictive hedge funds in favour of cheaper and more liquid ETF's, for instance).
Our base case, however, is focused on a slightly longer term view than just where markets happen to be this week or next month. On a 3-5 year view we think markets will be higher than where they are today. We also think that Asia and the Emerging Markets should continue to do well. This means that we continue to plan on increasing our exposure to risk assets over the coming months, thereby averaging out any seemingly irrational short-term swings.
This is less gung-ho than many, but also not as risk averse as some who continue to predict that markets will re-test previous lows and firmly believe that the rally in markets over the last three months is little more than a dead cat bounce. We don't think so, but still have plenty of cash waiting in reserve to increase our market allocations if markets do fall back.
The recent sharp rally in equity prices has encouraged us to review our cautious stance on equities many times over the last month or so, with the question being "Have we been wrong for the right reasons?". Or were we just plain wrong? Was it right to maintain caution in the face of some evidence that the substantial challenges facing the global economy are beginning to ease?
On March 10th our blog entry was entitled "Taking a step back from the gloom..." in which we highlighted 5 problem areas that we thought would have to be resolved in order for economies and markets to stabilise.
As it turned out, the date of that blog marked the bottom of the market - at least for the time being - with the S&P 500 Index having rallied by a sprightly 34% since then. It would seem to be the case that markets appear to assume that all of these core issues will be resolved satisfactorily. This seems a pretty big call.
Let's revisit the 5 points:
(1) It started with credit.
(2) Distressed asset buyers start getting involved/bank write-offs diminish.
(3) Property prices begin to stabilise.
(4) Trade growth recovers.
(5) Dividends (and earnings) stabilise.
The ongoing restructuring of the banking sector and the expected finalisation of the U.S. "stress tests" may help to alleviate points 1 & 2, even though the full workout phase is likely to take years. The price for this will obviously be increased capital requirements (from either shareholders or the government, or both).
The issue for property prices is less clear cut: whilst some buying of distressed properties is evident, it remains patchy on a global basis and severely constrained by the newly conservative lending polices on the part of banks ("Barn Door Closed. Horse Missing. Society To Blame"). This is notwithstanding the vast margins now available to them on their loan book. Perhaps prices have stopped falling precipitously, but that's far from saying that they are beginning to recover. It is also more than likely that, referring back to 1 & 2, banks have yet to recognise the full impact of the slump in commercial property values on their loan books, and this will have to happen to allow the clearing mechanism to take place.
Trade is still contracting. Worldwide. Again the rate of contraction may have slowed, but this may be as much due to the slowing of the brutal de-stocking process that has taken place in the last few months.
It is certainly the case that the Q1 earnings results have generally been better than expected, and maybe its uncharitable to note that this has been largely because expectations were overly pessimistic. We're still a long way off real growth, based on real cash flow (as opposed to write-backs of prior provisions etc.).
Does that mean that all talk of "green shoots" is little more than organic fertiliser?
We would admit that the recent rally has been sharper and larger than we ever thought either possible or justified. In this, it seems, we are not alone: a recent research piece from BCA showed that whilst most "top-down" economists are predicting flat earnings for the S&P 500 in 2009/10 after a precipitous drop of 45% in 2008, their equity research "bottom-up" colleagues are forecasting a near 50% earnings recovery over the same period. Granted, the track record of global equity research teams has been shockingly awful for far too long (consistently over-optimistic), but the disconnect this time is far more pronounced than at any time in recent memory.
Given this uncertainty, we went back to basics and pulled out the envelope, turned it over and wrote down our list of positives and negatives:
Positives
Negatives
+ Stimulus Packages
- Unemployment Still Rising
+ Bank Rescues / Car Company Rescues
- Commercial Property Values Falling
+ Credit Spreads Narrower
- Consumer Spending Uncertain As Savings Rates Rise
+ Q1 Earnings Better Than Expected
- IMF Forecasts Banks Need a Lot More Capital
+ Global Quantitative Easing
- How’s It Going To Be Paid For?
+ Investors Cash Heavy / Redemption Sales Appear To Have Ended
- Top Down Economists Still Very Negative
+ Commodity Prices Down
+ Inflation Down
- Worries About Inflation Reappearing
+ Interest Rates Down
- Bond Yields Must Rise
+ Bottom Up Research Analysts Forecast Earnings Recovery in 2010
- Earnings Forecasts Too Optimistic?
+ Global Risk Appetite Has Risen
- Confidence Still Very Fragile. Those With Jobs Worry About Hanging On to Them
What's interesting about this is that the list of positives has grown longer over the last two months, implying that the recent rally is not all just day traders who have been drinking too much coffee: there is some logical backing.
It does have to be said, however, that the list of negatives still contain some real biggies: the IMF's recent analysis suggests that they reckon banks will still need to recognise losses of a further $2- 3tn or so on top of the $1.5tn or so they have already recognised. That means more capital from either shareholders or governments or both. It also means more disclosures of losses. It will take a significant global economic recovery to whittle these down.
That said, we don't buy some of the other negatives, such as inflation worries and those doom laden predictions of a melt down in the bond market. Yes, yields will have to rise in order to provided a better market for all the new sovereign issues that must be made to pay for all the stimulus packages. Yields will not rise as a result of inflation at least for the next 12 months or so: whilst a substantial global output gap persists, producers will have little pricing power and will therefore focus on volume rather than value increases to absorb the slack.
On balance, therefore, we would admit that in early March it was easy to be catastrophically bearish. Since then, the level of government intervention has been so enormous as to draw a line under that bearishness.
For that reason we are now repeating our recommendation of last month that our portfolios should start gradually re-building an equity exposure, if they don't have one already. This time however, we feel that it appropriate to be specific and to target an equity weighting of between 10% and 20% depending on attitude to risk. In addition we're also planning to add exposure to high yield fixed income (where we expect to see further yield compression) and some commodity. All this means our cash weighting will be reduced to between 40% and 50% (still substantial and far higher than we would usually hold in "normal" market conditions).
Any equity market weakness will be used as an opportunity to increase the equity exposure. If, on the other hand, markets hold up and maintain their levels, at least we will have started to build a base from which to review our equity exposure in the coming months.
I will admit to being very surprised by the strength of markets since their recording of new lows on March 9th (only six weeks ago) . Since then, global equities have rallied by nearly 24%, with banking stocks and emerging markets leading the charge with gains of 62% and 31% respectively (and that's after adjusting for last night's sell-off). These are huge, nose-bleed inducing jumps.
I will admit that we've pretty much missed all of this and have viewed the recent rally as too far, too fast.
Is this right?
With the benefit of 20/20 hindsight, perhaps the low recorded on the S&P 500 of 676.53, represented a pointedly oversold level, particularly given the kitchen sinking approach adopted by the various global monetary authorities in the last 6 months. At some point all that money has got to stick, if only temporarily.
It is perhaps for this reason that the market rally has been led by the financial sector, which, up until March 9th had led the market down with a decline of 83.9% from its high of mid 2007 (even with the recent recovery, it's still down 74% from that level).
On that basis, although the financial sector continues to dominate the headlines for obvious reasons, the key to determining whether this rally will be sustained remains the health of the broader corporate sector and the earnings numbers it is able to produce in a tough economic environment. Recent reports are suggesting strongly that the forecast earnings number is following the market down (i.e. the market has been doing a better job than the research community of anticipating the bad news).
So far, the data therefore looks fairly grim: the argument must therefore be that with their recent sharp rally, prices have already more than discounted an earnings recovery of both a reasonable magnitude and one which will be making its presence felt by 2010. This is pricing in a lot of optimism.
As Gerard Minack of Morgan Stanley noted in a recent piece:
"At the early March low, the market was arguably pricing in $50 EPS (that is, a figure below the current 2009 consensus). At current levels, the market is either too optimistic about current-year earnings, or already focused on 2010. Or the current rally will prove unsustainable".
Note that Morgan Stanley itself is forecasting an more bearish than consensus EPS figure for the S&P of $40 for 2009 and $57 for 2010, implying current valuations of 21x and 14.5x respectively. Morgan Stanley also notes that US earnings now face several headwinds:
1.the weak domestic economy, 2.weak global economy (38% of US earnings come from offshore affiliates), exacerbated by US$ strength, 3.a reversal of inventory valuation gains (which could subtract 150 basis points from margins in 2009), 4.a reversal in financial leverage. Buy-backs (share count reductions) added 250bp to earnings in 2006, 300bp in 2007, and 87bp in 2008, 5.rising pension costs (estimated cost this year: 300bp).
"The offset from falling input costs and (for financials) a steeper yield curve will be only minor compared with these negatives".
It remains the case that credit markets are taking a much more cautious view than equities: credit spreads may have narrowed a bit over recent weeks, but they remain elevated and therefore continue to signal concern about rising default rates.
What does all this mean for equity markets?
We feel that being late into a rally (i.e. entering only after earnings momentum has clearly turned) is probably going to be less damaging than being too quick and jumping in before earnings have really bottomed.
That means we have to accept that chasing sharp bounces (such as this one) makes little logical sense and that a better strategy is to look to gradually re-build an equity exposure over a longer period of time: gradually building this over a period of months whilst trying hard not to get distracted by short-term gyrations.
A thought provoking piece from John Authers in yesterday's FT: "Is it back to the Fifties?" (FT, March 25th 2009), in which he discusses whether or not we have all been lulled into a false sense of security with the view that equities "will always outperform bonds over the longer term".
It is pointed out that following the 50% or so drop in equity values over the last 12 months, US stocks have now fallen more than 60% in real terms since the market peaked in 2000. Therefore "anyone who started saving 40 years ago has discovered that stocks have performed no better than government bonds".
On a longer term basis the picture is a bit less bleak: since 1900 US stocks have averaged an annual real return of 6% vs. 2.1% for bonds. However, "the problem is that they can perform worse than bonds for periods longer than a human working lifetime". Get a magnifying glass, or click on the image below for the illustrative chart....
The argument must therefore be that the "cult of the equity is dead and buried" and that hordes of investors will remain on the sidelines in favour of parking their money in low yielding but secure bonds.
Hang on a sec.
(1) If you take any asset class after a period of underperformance, it's always tempting to suggest that this underperformance is going to continue indefinitely. It never does (unless, admittedly, you've been invested in the Japanese stock market for the last 20 years). (2) Taking as your valuation point a moment in time after equity markets have have fallen by 60% in real terms over the last 10 years seems even more of a stretch, particularly with government bond yields at close to all time lows (in other words the divergence of the two asset classes is probably at, or close to it absolute widest point). (3) Equity markets are all about risk and its valuation. At the peak of bull markets, the equity risk premium is too low. The same applies in reverse with bear markets when the equity risk premium is high. I don't know whether or not we're at the absolute bottom in equity markets yet, but I do know that the perception of risk remains very high, and as a result equity prices have fallen to adjust for that. At some point the price of equity assets will have fallen to a level at which investors can take comfort that on a 3 to 5 year view, any risk has been more than discounted by markets. That's when you get a turnaround in sentiment and in markets. Ideally, one wants to start anticipating that by feeding money back into equities before the real rally has got into its stride.
What's more clear cut, however, is that, at least temporarily, investors of all types (from the so-called professionals down to the individual pension investors) will have a much healthier respect for risk than applied throughout must of the last 10 years. Thoughts which underpinned such tomes as "Dow 100,000" which were predicated on the fact that equities no longer deserved to be priced with any sort of risk premium have been exposed as utterly worthless. It's clearly a good thing that these myths have been de-bunked, but similarly they are no reason to throw equities away as a serious asset class.
If you've sat through the declines of the last 18 months grimly hanging on to your equity positions, then it's been painful. The rally of the last few weeks has been pleasant relief.
More importantly, if you've been sitting on cash over the last 12 months as we have, then at some point it's worth feeding some money back in to take advantage of mis-priced risk. We're starting to do exactly that, with an initial allocation to equity of 10% (no-one ever accused us of betting the farm...)
One area of additional interest remains the corporate bond market.
A good piece in today's Wall Street Journal notes that corporate bond spreads have not moved much since the beginning of the year: they remain at historically high levels and are effectively pricing in a default rate of 25% or so. As noted by the WSJ, this compares with "the worst five-year investment-grade default rate since 1970 [of] just 2.4%; the average is 0.9%".
This means that either the current equity re-bound is way overdone and that a wave of corporate collapses is about to hit us, or, that corporate spreads should start coming down to reflect an easing credit market reduced perception of risk.
Here's hoping it's the latter, but it's clear that the corporate spread chart is something we need to watch very carefully over the next few months: if it stays elevated or rises further then it's telling us to prepare for the worst. Conversely, any fall will be a big positive, since concern about corporate debt defaults will have fallen...
Although last night's market reaction looks a little excessive, the announcement of the anti-toxic debt plan, part II, represents a reasonably good step forward on the road to getting the US banks back on their feet and worrying less about staying in business.
As with all these things, the devil will be in the detail, but for the private partners to the Treasury's investment joint venture, it looks like a virtual no lose situation. The government will co-invest and provide the bulk of the funds required on a guaranteed, apparently non-recourse, basis.
Despite initial comments about taxpayer ire against yet another freebie for incompetent bankers, this version of the bail-out at least means that the government and the taxpayer are sharing in the upside (and benefiting from the taxes their partners will pay on any gains into the bargain).
Obviously the flipside is that for the programme to succeed, banks have to participate in a meaningful way. By so doing they not only get to offload a bunch of dodgy assets, but they also help to set a benchmark against which the remainder of their assets can be valued.
As things stand it will all come down to the price that is set: the government and private sector buyers on the one hand will not want to overpay, whilst the banks will not want to offload too cheaply should their actions help to stabilise the market. I guess objectively, that if Bank X offloads a portion of its portfolio at a cheap price, but by so doing helps to encourage increased demand (and higher prices) for the rest, then the initial discounted sale may be worth pushing ahead with.
Either way, we won't know until the autumn whether or not the plan is starting to achieve the desired result.
It is however another step in the right direction and away from concerns about the very existence of the banking sector and its impaired ability to finance genuine businesses and the economy.
On that basis, I would cautiously suggest that, if it started with credit, yesterday's clarifications are helping to clarify what is and will be done to resolve that part of the current mess (points 1&2 on the list of things to enable a recovery in the blog of 2 weeks ago).
You could argue, of course, that the 23% rally we have seen in the S&P over the last two weeks is overdoing things just a tad due to the widespread problems that exist elsewhere. A rise of 20% or more from any low is officially termed a "Bull Market", and it doesn't feel like one.
It is however a good start, and one that may start encouraging some gradual accumulation of equities - particularly if they fall back from these rather overbought levels.
Now all we need to worry about is the global economy....
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There has clearly been an element of linkage between this and the amount of "excess liquidity" that has even found its way into markets and helped to offset some of the value destruction that drained liquidity from the system in the second half of 2008.
(2) Increases in risk appetite: Whether or not sidelined cash is a factor, it is certainly the case that risk appetite has recovered, as fears over systemic shocks to the global financial system and economy have reduced from near panic levels.
