Professional Investor: The conditions are perfect for bargain hunters

It was not a good week for nervous investors. Monday's diving equity markets were followed by the US central bank being forced to cut interest rates on Tuesday. That doesn't sound like a very inspiring investment environment. But contrarian thinking can help to pinpoint exciting opportunities.

This was a fundamental crash brought on by the bursting of the credit bubble. US financial institutions have had to take substantial write-offs linked to the collapse of the US sub-prime mortgage market, while concerns have risen about European and Asian banks. These are real fundamental issues that have triggered an aggressive repricing of risk.

Last week, a number of issues deepened the crisis of confidence. First, the troubles in the monoline insurance sector, where Ambac became the first major triple-A rated bond insurer to be downgraded, showed that the sub-prime problems have spread. Weak US macroeconomic data forced market participants to face up to the reality of a serious slowdown – most likely, a recession – in the US. Poor earnings reports by some major US banks, in particular Citigroup, spooked the market. On Monday, investor nervousness turned to panic.

The Federal Reserve's response on Tuesday, cutting the fed funds rate by 75 bps, was resolute. Its action helped to steady the market. This isn't the first time that the Fed has acted between its regular meetings. It made an emergency intervention in October 1998, after hedge fund LTCM collapsed, for example. But Tuesday's intervention revealed a decisive Fed. Its action also allowed investors to take profits on bonds and to move back into equities.

It is strongly believed that the Fed will cut rates further, ultimately taking the fed funds rate as low as 2.0-2.5 per cent. We also expect the European Central Bank to cut rates later on this year as the economy slows, despite its tough talk on inflation. These moves are helping to make us reasonably upbeat about the outlook for equities. True, markets are likely to remain nervous for some time. In the near term, consumers and corporates are likely to tighten their belts. It may require a clearer picture of the strength of corporate earnings for equity markets to regain any significant forward momentum.

But there is a palpable sense of relief now. The capitulation selling is largely over. We feel that most of the damage has been done. What is behind this quiet confidence? Interest rates are being eased aggressively. Banks have taken all the pain of write-downs in one go, while their actual losses may be much more limited. We also feel that a nervous market is over-reacting to the problems in monoline insurance.

Valuation is another support. Equities are certainly not expensive. Indeed, we feel there are tremendous opportunities at the moment. As an example, look at what has happened in the UK house-building segment over the past couple of weeks.

The share price of Persimmon had fallen by almost 60 per cent from its high at the beginning of last year by 9 January this year, battered by declining UK house prices and high UK interest rates. By then, it offered tremendous value. Its dividend yield was 8 per cent. In the next nine trading days, the share price rose by over 30 per cent as investors realised the sell-off had been overdone.

Who would have thought that house builders would do so well at such a time? That is the key. We try to remain contrarian at all times, especially in a bear market. But we are contrarian only where we have trust and conviction. That approach feeds our view on financials, where we see similar opportunities. Clearly, this is the sector that has been affected most by the bursting of the credit bubble. And financials remains one of the sectors most at risk.

Against that backdrop, we still don't like the larger companies in the US. We are also wary about financial risk in Asia. And in areas where there is a lack of clarity, such as in European banking stocks that have either engaged in takeovers or have not yet fully disclosed all their credit exposures, we do not have conviction and thus remain cautious. But in Ireland, banks are trading at a P/E of just five, and have dividend yields of some 7 per cent. That makes them attractive. We also like some US regional banks, mid-sized operations with traditional business models that are not involved in investment banking. It might look bleak but there are genuine opportunities for those who are prepared to take a contrarian view.

Wouter Weijand is the manager of the Global High Income Equity Fund at ABN AMRO Asset Management in Amsterdam

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