Jonathan Davis: America's tragedy may be the catalyst to market reform

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It may just be a stubborn Panglossian streak, but I cannot find it in me to be downcast at the market fallout from the terrorist attacks on New York and Washington. It is not merely that the cause of the American-led coalition is just and the prize to be gained from a successful campaign against terror well worth the inevitable short-term cost in economic and psychological dislocation.

It may just be a stubborn Panglossian streak, but I cannot find it in me to be downcast at the market fallout from the terrorist attacks on New York and Washington. It is not merely that the cause of the American-led coalition is just and the prize to be gained from a successful campaign against terror well worth the inevitable short-term cost in economic and psychological dislocation.

As important from an investor's perspective is the sense that the events of 11 September may yet be a catalyst that brings down the curtain on several years of complacency and irrational pricing in financial markets whose consequences have been far from an unalloyed good. If that is the case, and it is still too early to be sure, it would be a welcome demonstration that even terrorist outrages can have a positive side.

In the short term, much remains to be determined. Only the mealy-mouthed can continue to pretend that a recession can be avoided in either the United States or Europe. It was almost certainly on its way before 11 September, and the short-term impact of that event has clearly compounded the slowdown in economic activity that has been occurring on both sides of the Atlantic. The hits to consumer confidence and travel and tourism are real.

But there is nothing yet to say that these effects need be more than temporary. Until the precise shape of American military and economic retaliation becomes clearer, there will continue to be anxiety and uncertainty. But it is not implausible to think that the net effect of what has happened may well be to accelerate the economic recovery that eventually takes place. The truth is that the world economy probably needed a purgative recession of some sort and the terrorist attacks may only have added to a process that was well underway already.

The behaviour of financial markets certainly supports such a conclusion. The scale and duration of the bear market that has developed in the 18 months since the stock market peaked in March 2000 have beenstriking. What we have lived through is the second worst global bear market of the past 50 years; only the 1973-74 experience was more severe.

It depends which measure you adopt, but the best estimate of the scale of the downturn I have seen is that the world's stock markets have fallen by slightly over 40 per cent in real terms over the last 18 months, a decline of historic proportions. Every leading market has suffered. Only the Australian and Dow Jones indices have declined, peak to trough, by less than 30 per cent. (In the US markets, the broader S&P 500 index has fallen around 35 per cent and Nasdaq, the technology market, by more than 70 per cent.) Many markets in Europe are down by 40 per cent.

The declines of 12 to 15 per cent, now partially reversed, that took place in the week following the terrorist attacks have to be seen in this context. You cannot make the case that the events of 11 September have caused the markets to crack; rather, they have merely added to the pressure on an already fragile structure. From a long-term perspective, the remarkable fact is that even after a bear market of such dramatic proportions, the US stock market had still only come down to a level that puts it at the upper end of its long-run historical valuation range. On the basis of Tobin's q, for example, the measure favoured by investment consultant Andrew Smithers, the US market still has some way to fall before it can be said to have reverted to its historical mean (as the chart above shows).

Looking at the UK, the effect of the bear market has been to push the dividend yield above 3 per cent for the first time in some years. This is progress of sorts, unless you can remember the time when the stock markets almost always traded in a range between a 3 per cent and 5 per cent yield, and the former was a usually reliable "sell" signal. (Admittedly, because of share buybacks and other effects, the yield on today's market is probably nearer 4 per cent on a truly comparable basis.)

From a trading perspective, the market has been heavily "oversold", which implies that rallies of varying strength are probable in the next few weeks. Many fund managers have certainly come to the same conclusion and are positioning themselves to benefit if the recovery seen last week in the equity market continues. From the Federal Reserve downwards, central banks are clearly ready to do as much as they can to pump liquidity into the system, which in the past (for example after the Long Term Capital Management hedge fund collapse in 1998) has eventually had a positive impact on equity markets.

Nobody should imagine that we are through the process of revaluation that is necessary to restore market valuations to sustainable levels. The process is, however, clearly underway; and whatever the final impact of the war against terrorism, it certainly makes it less likely we will see a return to the "bubble" conditions of 1995-2000.

For now, in my view, investors should retain a relatively conservative balance between equities, bonds and cash in their portfolios; should expect to see stock market rallies in due course, even as economic news deteriorates; and should look forward to a new era when shares will again offer good fundamental value.

davisbiz@aol.com

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