Hamish McRae: Marconi's plight may help us spot the bottom of the telecoms bear market

As the bad news continues to unroll, the wise begin to look for signs the worst is over
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How do you spot a turning point? When it is too late to do anything about it.

How do you spot a turning point? When it is too late to do anything about it.

The downgrading of hi-tech securities over the past year has been one of the most vicious market trends for a couple of decades. It is the nature of markets to overdo things and anyone thinking back to, say, the emerging market crisis four years ago, will note that excessive exuberance, whether it seemed rational or not at the time, usually gets punished in the end.

But all bad things, as well as good, come to an end. As the bad news continues to unroll, the wise begin to look for signs that it might reverse itself. One seemingly unscientific signal is a collapse in confidence – or even more clearly, a bankruptcy – in a major player. For people with very long memories it was the collapse of Burmah Oil in January 1975 that signalled the bottom of that bear market and sharpest recovery in British share prices of all time. For people with less long memories it was the collapse of Olympia & York, developers of Canary Wharf, that signalled the London property boom of the past decade. Happily O&Y retained a foothold in the development and has subsequently prospered, unlike Burmah, which had to sell its key asset, a large shareholding in BP, to the authorities at a knock-down price.

This time the pressure is not on oil companies, nor on property, but on hi-tech companies in general and telecoms in particular. We are not yet in a Burmah situation with hi-tech yet, but – to put it unkindly – the plight of Marconi, helps us along the way. Bad news is good news, partly because until problems are out in the open they cannot be solved and partly because until capacity is taken out of the market, profits cannot be rebuilt.

To write in this way is, however, to look at the world though myopically British eyes. Capacity has to come out of the world market: unwise investments have to be written off globally for the excessive gloom to be dispersed.

To see how gloomy US markets are about the prospects of the second and third division telecom companies have a look at the graph on the left. It shows the yield on these companies' bonds, which have now shot up to more than 20 per cent, from 12 per cent at the beginning of last year. You might think that 12 per cent is pricing in quite a lot of risk. When you get to 20 per cent and comparable government securities are yielding 6 per cent, the market is saying that there is a very good chance that most of these bonds will not be repaid at par. These are not dot.coms: they are real businesses with real revenues, rather like One.Tel, the failed Australian phone firm whose UK activities were bought by Centrica this week. Expect a series of defaults and financial rescues in the months ahead.

If the graph on the left demonstrates market misery, the one of the right shows corporate hope. This is also US data, but I am taking that because the cycle is more advanced there. It is also broader data, the extent to which companies in general are bringing out revisions to profit forecasts, rather than just the plight of the telecom or other hi-tech industries. But the evidence of a turning point is sufficiently marked to be worth noting. There is more bad news on the way, of course, but the rate at which the bad news is accruing seems to be slowing.

Once the market gets a whiff that there might be a turning point expect a recovery. The question then is whether a narrowly based financial market recovery is sufficient to boost the US economy, and hence the world economy. It is a necessary condition but it is not a sufficient one.

The mainstream view of the professional investment community is that the US economy will recover in the second half of this year, and that it will resume something close to trend growth in 2002. In other words, the present slowdown will be similar to the pause in growth in 1998, rather than the, albeit mild, recession in 1990-91. The aggressive rate-cutting by the Fed will succeed. On that basis, the various investment banks recommend you to buy securities, arguing in particular that the telecom companies' securities are oversold and are due for a recovery.

The minority view is that we are in for a standard cyclical recession, despite the rate-cutting, because the imbalances in the US economy will take two or three years to correct themselves and this will only happen in recession. US savings will have to be rebuilt and US companies will have to take out more capacity to cut costs and restore margins. On that view, putting money on to the market in general carries too much risk, though there are always specific opportunities.

My own view, for what it is worth, is that the more negative minority will prove right on the economy – but the more positive majorities will prove right, at least on a six month view, on shares.

Perverse? Well, not really. Go back to the bond chart on the left. The jump from a yield of 12 per cent to one of more than 20 per cent is enormous: anyone who invested in January 2000 will have lost something approaching half their investment. But at some stage the risks are adequately accounted for.

Think back to the emerging market crisis. Anyone who was prepared to invest in a broad range of securities in emerging markets six months after the crisis hit will have done fine. Of course investment has to be selective. The prime characteristic of these cycles is that in the downswing the good get swept down with the bad, while in the upswing people have more time to make a judgement and therefore the good do not pull up the bad. Nevertheless, anyone who invested blindfold with a pin will still be ahead.

You have to be profoundly pessimistic about the US telecommunications industry to believe that the risks are not covered at 20 per cent yields. OK, so they go to 25 per cent for a bit. Some companies go under. But eventually real businesses will produce real returns, even if there is a second leg to the US downswing that is not generally priced into the market.

That is the trouble with turning points. By the time it is clear they have taken place it is too late to take advantage of them.

My guess is that the turning point for hi-tech shares is still another three months off. But every Marconi-ish story brings it closer.