Secrets Of Success: Between euphoria and Armageddon
Saturday 04 March 2006
We all know that it takes two to tango, and thousands to make a market. There would be no need for financial markets if investors did not have regular differences about what the future holds. Yet I find it difficult to recall a time when there have been such contrasting views about the sustainability of current market trends.
The nearest recent parallel is probably the crazy 1998-1999 period, when most conscientious fund managers, used to valuing shares on old-fashioned measures such as p/e ratios and dividend yields, found themselves baffled by the final stages of the internet bubble, which temporarily took leave of such mundane matters.
Are we heading into that sort of period again, except this time on a global scale? There are certainly some echoes in the bullish arguments now being put forward to justify where the markets currently stand. Listen, for example, to the latest monthly report from the strategy team at Credit Suisse (which is representative of several others).
Their argument is that the outlook for equities is for "more upside ahead". Reading their report gives the impression that there is hardly a cloud in the sky for investors (though a more careful reading suggests to me that they just think there is still momentum in the market - some of their arguments could just as easily be turned round to argue the opposite case).
They give four reasons for their general bullishness. The first is that the global macroeconomic environment is still better than most investors are expecting. There are clear signs of recovery in Europe, Japan and China, they say, the corporate sector remains in rude financial health, and there is nothing to suggest that the slowdown in US consumption growth and housing activity will derail the global economic recovery. (In fact, they say, it may serve a useful purpose in stopping the global economy overheating.)
The second reason is that corporate profits are expected to continue growing at a reasonable rate of 5 to 6 per cent this year. Although profit margins and the profit share of GDP are at an all-time high (which would normally be taken as a warning sign, given that this is a mean-reverting series), the Credit Suisse strategists argue that 60 per cent of the improvement in profitability is down to permanent rather than cyclical factors.
A third reason for bullishness is that on simple measures, valuations "still look pretty compelling", by which they mean that in both Europe and the US, the free cash-flow yield of quoted companies remains above corporate bond yields. As a result, there is "a huge scope for further M&A activity" (buying a company that generates 7 per cent in cash when you can borrow to finance the deal at a lower rate is an obvious incentive for Company A to buy someone else).
In fact, on Credit Suisse's numbers, just over half of Europe's quoted companies have cash-flow yields above equivalent corporate bond yields, making them a potential magnet for both private equity and public-company deals. What is more, they say, recent takeover deals suggest that even the share price of bidding companies has been going up when deals are announced, making M&As still more attractive.
The final reason for bullishness that the Credit Suisse team gives is that the main tactical indicators they look at - such things as corporate repurchases of shares, investor sentiment and appetite for risk - are not yet giving negative signals (but nor are they strongly positive, it has to be said). Apart from Japan, in their view, there is no evidence that the markets are "overbought".
Throw in the fact that the forward p/e ratio of the global equity market is still below its average level since 1991, and you have the conditions for a further market advance. In fact, they say, there is a real chance that the appetite for risk among equity investors may yet rise to "euphoric levels".
Well, it may happen that way - markets have done stranger things before, and you have to be brave, especially as an investment- banking strategist, to stand in the way of strong momentum, which is where the deals and commissions lie. But there are also some powerful arguments to put on the other side, mainly to do with risk and the fact that markets don't (and can't) just keep on going up through thick and thin.
By contrast, consider the views this week of Ian Rushbrook, manager of the Personal Assets Trust, based in Edinburgh. He and his fellow-director Robin Angus say, in their latest quarterly report to shareholders, that they fear "a self-sustaining financial tsunami of falling asset prices - equities, property, index-linked securities and conventional fixed interest alike - that would sweep away all in front of it".
In their view, a closer analysis of what has been driving the markets upwards in the last three years indicates that all the trackside signals are flashing red for danger. They don't find valuations in the US and UK equity market particularly attractive - it is easy to forget that today's UK equity market valuations, while low by more recent standards, are only marginally better than those that prevailed in the run-up to the 1987 stock-market crash.
But it is what is happening in the bond markets that is much more "scary", they say. The inverted yield curve in the UK - which means investors get more for putting the money in a bank account than they do for lending to the Government for 50 years - is "barely sane".
What is happening in the index-linked market is "even more surreal", thanks to panic buying by pension funds. Simple maths shows that if the real yield on long- term index gilts was to rise from 0.5 per cent today to 2 per cent, their value would fall by 40 per cent. If yields go to 4 per cent, prices will fall by 70 per cent. That, says Rushbrook and Angus, is "Armageddon - an investment bloodbath".
There is not enough space to do justice to their analysis of why the US mortgage market holds the key to what happens next (you can read it in full on my website, www.independent-investor.com). Suffice it to say that they think a reversal of the massive refinancing of mortgages in the US that has happened in the last few years will be the trigger for bringing the powerful upward trend in all financial assets over the past three years to an end, with painful consequences.
So, there you have it - global euphoria or Armageddon. Which will it be? Short term, it is impossible to say for certain. Markets are unpredictable on that kind of timescale. But the medium- to long-term investor, with an eye for risk, will surely not want to get caught up in too much euphoria this year. Although I remain keen on Europe and Japan, too many of the experienced professionals I talk to are cautious, for me to buy the whole Credit Suisse story. We certainly live in unusual times.
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