Financial Markets Are Cheered

Posted on: 21 October 2008 by Gareth Hargreaves

Finance expert Graham Kerner rounds-up the financial week.

After the traumas of the previous week, global financial markets roared their approval at the concerted actions of the world’s major policymakers which saw the UK government lead the way with a radical package of support for our financial system.

Gordon Brown announced a bail out of three of Britain’s largest banks and promised to pump some £350bn into the system to ease liquidity – the move was breathtakingly daring, but seen as a blue-print for success and was swiftly copied by European governments and the US.

Having been pummelled for weeks, equities fought back and investors enjoyed some of the largest one-day gains ever witnessed with Wall Street rallying some 11.2% on Monday.

So is the worst over and where do we go from here? To answer this we took The Daily Telegraph’s advice and spoke to some of the handful of fund managers who the experts say have a proven record of beating bear markets in the past.

Edward Bonham Carter, Jupiter’s chief executive, gives his views on these events.

“The UK Government has today announced it is pumping £37bn into three of Britain’s largest banks in order to stabilise the country’s financial system. Under the plan, the government will inject up to £20bn into Royal Bank of Scotland, £11.5bn into HBOS and £5.5bn into Lloyds TSB in return for a mixture of ordinary shares and preference shares in the banks.”

“This announcement followed an emergency summit of eurozone countries over the weekend, at which world leaders agreed a plan to guarantee lending between banks and step in with state funds to support the banking system – a move made in response to sharp falls in global stock markets in recent weeks.

“Following the injection of cash, taxpayers could own 60% of RBS and 40% of the merged Lloyds TSB and HBOS, who have renegotiated the terms of their deal. Investors should take comfort from the fact that governments are responding to the crisis and seem prepared to ‘do what it takes’ to avoid a collapse of the financial system. They should also be reassured that the decision by the UK government to take stakes in the banks rather than to nationalise them means that there is the potential for profits to be made from the arrangement over time.”

“Stock market indices have shown their support for the measures, displaying healthy gains on their announcement. However, investors should expect continued volatility in share prices in the short term as concerns and fears over a substantial economic slowdown, which would have an impact on the earnings prospects for many companies and sectors, obviously remain.”

“In addition, many asset classes, such as corporate debt, leveraged loans and other credit investments, remain hard to trade, leaving equities as one of the few investments people can sell easily to raise cash. However, in my view, the bleak outlook for the global economy has largely been priced into the value of many shares. As a result, shares of a number of large companies seem undervalued and are yielding between 5% and 7% which, in the context of falling government bond yields and the likely falls in interest rates, look attractive once concerns over liquidity in the system subside.”

 “For those investors who have personal debts or have a short term requirement for cash, I can see the rationale behind a decision to sell equities. I can also sympathise with those who decide to sell because their ability to tolerate volatile markets has evaporated. But I believe we will see higher equity values from these depressed levels.”

“I am not saying the market will not go lower: it may well do so. But, if one believes, as I do, that the capitalist system will emerge – albeit with less borrowing and more state involvement – then equities present good opportunities for investors taking a long term view.”

“We are now in a world facing significantly lower growth as companies will be borrowing less as they scale back their investment plans. Consumers will also borrow less. As a result, interest rates will be materially lower, possibly falling to 3% or lower in the UK over the next year, and investors will need to find sources of safe and reliable income.

“This is why I believe that one of the enduring themes to come out of the credit crunch and market turmoil will be a return to ‘back to basics’ investing. In other words, I think we will see a move away from the tendency for investors to chase an apparently high income that has been ‘manufactured’ from complex, leveraged and ultimately risky structures. In the new world, therefore, investors are likely to shift back to traditional income investing.”

“It is worth remembering that over time, the majority of investors’ total returns from equities come from dividend growth and the reinvestment of those dividends. Profit warnings will undoubtedly increase, some companies will have to cut their dividends and the overall yield on the market will fall as the banks cut their payouts. But there are still plenty of large, well-managed companies that will be able to grow their dividends and being able to buy their shares on high yields looks significantly more attractive than the returns investors can get elsewhere.”

“I have been impressed by the resilience of our investors during this crisis. They have shown no signs of panic and clearly recognise that investing in shares is for the long term. We have also seen many willing to add money to their funds during the current weakness on the view that shares will recover from their current lows. This is an approach we agree with. It is also worth noting that in such conditions, the practice of drip-feeding investments into the stock market through regular savings schemes can prove beneficial.”

“Our approach remains to invest in high quality companies with solid balance sheets that have the ability to grow in a difficult environment. It is part of the skill of Jupiter stock-pickers to identify which companies are likely to do well for investors over the medium to long term and emerge from this crisis in stronger positions than they entered it.”

So Far So Good

One way of summing-up how people felt about the credit crisis was succinctly put by The Daily Telegraph who quoted the words of Mark Twain.

“Investors are more concerned about the return of their money, than the return on their money”.

Veteran investor John Hodson of THS Partners felt a lot more comfortable following the week’s actions by the government, saying:

“We were not in a very comfortable place last week, reasonably well-off individuals and businesses were worried that they weren’t going to be able to get their money out of the bank. Following Brown’s actions it looks as though a base has been put under this so, where I think we are now is, so far so good”.

His colleague Simon Edelsten agreed.

“The issue of whether people’s deposits are safe has been dealt with constructively. Because we felt this was a step in the right direction and notwithstanding we still have a recession to get through, we did reduce our liquidity last week by around 5%, dipping our toes back into the equity markets.”

“There are several encouraging signs for us – last week the yield on equities became higher than the yield on government bonds and in Japan that yield ratio was crossed in the spring. Back then we bought some Japanese stocks and that worked well. The last time we saw this crossover of yields in the UK was the first quarter of 2003 which actually turned out to be the start of a new bull market. We are not saying that we are quite there yet but markets have come down an awfully long way and this indicator of value is saying one should be positive again for the first time in five years”.

Whilst the government has found many plaudits for its initial plans to restore the UK financial system to good health, it is clear that further action needs to and will be taken by the authorities. As The Sunday Times noted, here in Britain, Lord Turner, chairman of the Financial Services Authority has pledged to take a tough line with City traders and bankers.

“There will be more people asking more questions than before. There is no doubt that the touch will be heavier” he says.

Turner also went on to say that international leaders and regulators must also work together to ensure there is no repeat of what many consider to have been a greed-led credit crunch.

Second Thoughts

The collective sigh of relief from global investors was palpable following the bail-out of some of the world’s largest banking issues as the view was taken that the plan would work, albeit with a time-lag.

But with increasingly febrile markets the focus shifted from the banks to the world economy, with traders working themselves into a sweat over the looming global slowdown. With share prices once again heading south mid-week,  The Independent explained to its readers that the sell-off was prompted in part by warnings that China’s economy would ‘pause for breath’, according to the finance director of mining giant Rio Tinto, Guy Elliott.

He says “We are confident about the future in China, but at the moment there is a deceleration of demand that won’t pick up again until next year”.

His comments alarmed the commodity markets, causing the price of oil to fall by 5%, leaving the cost of a barrel below $70 – less than half what it was back in July. Indeed, the slide in the price of crude has galvanised the world’s major oil producers to convene a meeting of their cartel, OPEC. As The Times observed, whilst cheaper oil is good for motorists, it could have serious consequences for the public finances of many oil-producing nations.

Whilst talk of recession is not being encouraged by the Government, it does recognise that the UK economy is slowing and it’s likely that GDP figures for the third quarter, to be released later this week, will show that the economy contracted.

The Sunday Telegraph reported that the economic think-tank, the Ernst & Young Item Club (which uses the Treasury’s own model), will warn that Britain is already in recession and that the economy will shrink by 1% in 2009. As the evidence mounts, the Chancellor was reported in the press as planning to fast-track public spending on major building projects to give an emergency boost to the economy, according to The Financial Times.

The move will see cash being transferred from planned budgets in 2010-11 to fund projects now. Mr. Darling will argue that it makes sense to accelerate public spending to prop up the economy in the hope that a recovery is underway by the time the spending gap appears in two years time. The Chancellor will set out his plans in next month’s pre-Budget report.

Take A Cue From History

So by the end of the week it was clear to investors that markets would remain volatile, with prices rising and falling throughout the week as the markets’ mood vacillated before finally ending the week on a positive note. Most major indices notched up gains of between 2%-3% as investors decided, on balance, that the foundations of recovery had at long last been put into place. The issue of volatility and what it might mean was discussed in The Financial Times who looked at the Vix volatility index – Wall Street’s gauge of fear.

The Vix index hit a record of 81 mid-week, meaning investors were demonstrating unprecedented levels of risk aversion, but the paper went on to explain that extreme readings on Vix have been a reliable contrarian indicator for equity markets, having successfully called major turning points over the years.

One of the reasons that share prices have fallen in the short-term is that, in the view of The Sunday Telegraph, equity markets are simply victims of their own liquidity. They have provided the only exit for distressed hedge funds, over-leverage private investors and derivative managers seeking to offset risk elsewhere, adding to volatility.

The Financial Times went on to say that another indicator used by experts is to look at trading data. When New York crashed in 1987 there were 1,174 new price lows: about 57% of the shares traded that day. Last Friday week there were some 2,901 new lows recorded – about 88% of shares traded, implying indiscriminate selling by investors.

Historically, when this happens, the next move is far more likely to be up rather than down. So assuming history and these contrarian indicators have not lost their predictive power, the paper said one shouldn’t be surprised to see the US market trading higher in the coming months.

Another way of looking at why share prices often do the opposite of what many people expect is that the stock market is forward looking, an aspect discussed by The Sunday Telegraph in its ‘How to survive a bear market’ article. The events of last week have made investors more wary about global recession which most might think will further depress share prices.

The reality is actually quite different because during the last three recessions share prices actually rose as was seen during the early 1990s, when despite the UK economy continuing to contract for two years, share prices went up. Similarly, in the Great Depression, 1932-33 were times of high unemployment and economic difficulty, but the stock market produced positive returns of 34% and 25% for each of those respective years. Therefore, if you want to capitalise on the stock market’s return to strength, or mitigate existing falls, do not wait until the economy has recovered.

Voices Of Experience

Fortunately at times like these there are veterans to call upon, investors who have been though similarly difficult times. Anthony Bolton, now retired, but renowned for his inspired fund management at Fidelity is undeniably one of the UK’s most seasoned investors and shared some of his thoughts.

He says “My recommendation is not to attempt to time markets, but to take a long-term view. History has shown that the patient investor has been rewarded by the long-term upward trend in equity prices. The worst mistake a private investor can make is to be sucked into the markets when they are high only then to get shaken out at times like this when prices are falling and the outlook is uncertain. It normally takes many years to recover from this experience so please don’t let it happen to you”.

On the other side of the Atlantic another veteran, Warren Buffet – renowned investor and the world’s wealthiest man – talked to the New York Times about what he has been doing with his own investments. “The financial world is a mess both here in the US and abroad. Its problems have been leaking into the general economy.”

“In the near term unemployment will rise, business activity will falter and headlines will continue to be scary. So I’ve been buying American stocks. Why? A simple rule dictates my buying: be fearful when others are greedy and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month – or a year – from now. What is likely however is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up.”

“A little history here: during the Depression the Dow hit its low on 8th July 1932. Economic conditions though kept deteriorating until Franklin Roosevelt took office in March 1933. By that time the market had already advanced 30%.”

“In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price. Over the long-term the stock-market news will be good. In the 20th century the US endured a host of problems. They included two World Wars, the Depression; a dozen or so recessions and financial panics . . . yet the Dow rose from 66 to 11,497. I don’t like to opine on the stock market nevertheless, today, my money and my mouth both say equities”.

Sounds like a good point to finish on.

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