Investors await sign it is safe to go back into stock markets

Traditional 'buy signals' and low valuations are not enough to attract buyers
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The Independent Online

With stock markets in the doldrums, a period of stability and some sign of economic encouragement at the very least are needed before they start to recover. Both the FTSE Eurofirst Index, which monitors major stocks across Western Europe, and the US's S&P 500 indices are trading at less than half the values of their highs reached late last year. The FTSE 100, the UK's benchmark index, meanwhile, this week hit a more than five-year low after losing about a tenth of its value. It has now wiped out all gains since mid-2003, when it was still digesting the implosion of dot.com boom.

Across the Atlantic, investors piled into government debt, viewing it as a safe haven. By contrast, corporate bonds, mortgage securities and other private-sector debt instruments continued to plunge in value, amid growing concerns that a global recession will lead to a new wave of defaults and losses.

But the average projected yield on share dividends has nominally surpassed that on government bonds. This is normally a buying signal for shares. But maybe not this time because it doesn't take into account the fact that many banks, which are being bailed out by governments worldwide, will not pay out dividends to shareholders. And as the economy worsens, businesses across sectors will also cut dividends.

And investors are still traumatised by the shocks of the past few months, like the bankruptcy of US investment bank Lehman Brothers in September, and do not know how the landscape will settle. "People need the market to reach a bottom of some sort and stabilise, so that they can then look around and take in the new order," said one senior City investment banker.

Just like when the valuation bubble led to the market highs of recent years, there now seems to be an inverse contraction that is likely to drive shares below their rational valuation.

"Just like people are over-exuberant in a rising market bubble, when we are in a downturn like this people panic and it's all doom and gloom, so valuations risk going too far the other way even if they have crossed the level of fair value," said the banker.

Uncertainty is the enemy of investors, and markets have been difficult to read for several reasons. One is the increased presence of hedge funds: they have had to sell out of equities and other positions to return money to redeeming investors, and also to pay back banks that are calling in the loans they have given out as they deleverage. This has led to stock movements that do not look rational and are not easily explained – spooking investors further as it undermines certainty.

An example is banks. Last summer, after the first few months of the credit crunch, their shares had fallen more than other sectors and some viewed that as a buying opportunity. But then Lehman went bankrupt in mid-September and turmoil hit banks with a vengeance. The Bloomberg European Banks Index has lost more than half its value in just the two months since mid-September. Those that did go back in have been burnt, and their experience is likely to put off others from showing similar confidence.

What it needs is a positive catalyst. But that is unlikely to happen soon. "Low valuations in themselves will not be enough to cause a rise in the stock markets," said Nick Nelson, head of European Equity Strategy at UBS. "Things don't just stop rising because they are too expensive or falling when they become too cheap. You need a catalyst. And right now it's hard to see a positive catalyst."

This week has seen more doom and gloom throwing back to the early-1990s recession and beyond. The UK saw the lowest number of English housing starts on record, and US unemployment rose to its highest level since 1992. And if economic news has been bad, corporate news has hardly given any opportunity for cheer. On Wednesday, the German chemicals company BASF lowered its full-year profit outlook for the second time. In the financials sector, which started the recession but shows no sign of leading the economy out of its doldrums, Citigroup announced job cuts exceeding 50,000 this week. And meanwhile the Detroit-based carmakers Chrysler, Ford and General Motors are negotiating with the government to secure a package to stay afloat. "All we have had is a slew of bad news – terrible economic data this week out of the US and rising unemployment," said UBS's Mr Nelson. "All that plus technical factors like continued deleveraging by hedge funds means the market has gone [down] through its support levels."

And when different parts of the US economy are running to the government and need clear decision-making, the US is in a sitting duck administration until Barack Obama can take office in January. So after another traumatic week for global markets we are still waiting for a signal of recovery. And with politicians and central bankers predicting more than a year's recession, it seems unlikely to do so soon.

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