Professional Investor: Be disciplined to avoid the turbulence
Saturday 19 August 2006
Geopolitical reasons aside, I believe the volatility in stock markets witnessed over the past three months has been triggered by a change in perception about the outlook for global interest rates. For some time now investors have been particularly focused on what is happening to US interest rates and questioning how much further they are likely to rise under the Federal Reserve chairman, Ben Bernanke.
However, rising interest rates have also been a pattern around the globe - from Japan, across Asia, to the likes of Iceland - and there is a general perception that central banks are currently in tightening (raising interest rates) mode.
Market commentators are now posing the following questions: have central banks in certain countries lost control of their economies? Are they behind the curve? And furthermore, will they be forced ultimately to overreact during this tightening phase, leading to recession in one or more economies, particularly the US, which would then have a knock-on effect around the world?
All stock markets, including the UK, are subject to sharp disconnections due to the number of short-term operators in markets these days, such as hedge funds and day traders.
The volume on the UK stock market has been growing progressively over the past few years and is now up at about 1.5 to 1.6 times the total market value of the UK traded in any one particular year. Therefore, the average holding period for equities is merely a matter of months.
Indeed, there are a lot of people who are taking relatively short-term views about the stocks they hold - sometimes supported by leverage. For example, I believe that what we witnessed in May was due to a number of investors taking risk off the table altogether primarily via option activity - that is, the selling of futures - which had obviously a depressing effect on the whole market.
This culminated in a very risk-averse period, where anything that had any hint of extra risk bore the brunt of May's downturn particularly hard.
Obviously, one looks for opportunities when stock markets experience as sharp a decline as occurred in May, and I believe that, in some areas, there are opportunities that have come to light. In all my funds there has been a gentle move progressively up the market-capitalisation scale, and I am finding value in the larger stocks in the FTSE 100 - for example, BP and HSBC. But at the same time there is still a significant bias towards small-cap and mid-cap stocks in my funds, and structurally I expect to remain biased towards mid- and small-cap stocks.
Most UK investors are concerned about the implications of a slowdown in the US and its potential knock-on effect around the globe, imbalances in the UK economy, and UK government spending. Indeed, Gordon Brown, is pulling in the reins hard on government spending, which has been an engine for the UK economy in the recent past.
In terms of the UK consumer, I believe that consumer spending will likely flag towards the second half of this year as higher utility prices and interest rates take their toll.
However, the UK stock market has been recycling these worries and concerns continuously for some time now, and this has had an overall depressing effect on equity valuations - certainly in an absolute sense and relative to the value of bonds.
The current earnings yield on the equity market is above nine, prospectively. It is easy to find stocks with reasonably defensive earnings outlooks and a number with decent levels of prospective growth - for example, the aerospace company Rolls-Royce.
Looking ahead, I believe there is currently good valuation support in the UK market, especially after an initial sharp decline in May, and a fairly volatile time since then. We are in the interim results season now, with some significant companies reporting.
I would expect to see a continuation of the pattern we have witnessed: corporate UK in good health, good profit numbers, particularly good cashflow numbers and balance sheets in good condition in companies that are in the position to be disciplined and focus on shareholder return, share buybacks and dividends.
Ed Burke is the manager of the Invesco Perpetual UK Aggressive Fund and the Invesco Perpetual UK Growth Fund.
Sean O'Grady is away.
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