Financial Markets Up & Down

Posted on: 22 July 2008 by Gareth Hargreaves

Expert Graham Kerner disects a week of wild ups and downs for shares.


As the UK economy struggles, global equity markets endured a roller-coaster week.

Bears Squeezed

Last week, investors experienced what were probably five of the most remarkable, bordering on bizarre, trading days in the history of financial markets. As The Financial Times pointed out, the US banking sector lost a quarter of its value and then registered a 33% gain. Oil fell more than 12% and 'short-sellers' were squeezed hard by the regulators as they tried to get back in the driving seat.

Monday saw the markets in positive mood following news that the US Treasury had announced it would support America's two largest mortgage lenders, Fannie Mae and Freddie Mac. Unfortunately, the good mood didn't last long, evaporating on fears that there really must be a serious problem - which didn't augur well for the regional banks. While stocks headed south, oil tentatively rallied, edging up close to its all-time high.

Tuesday turned into a wild rollercoaster following a downbeat testimony from US Federal chairman Ben Bernanke before the Senate Banking Committee - he painted a picture of twin threats to the economy in the form of rising inflation and weaker growth. Equity markets immediately slumped, taking the oil price with them as traders responded to the bearish comments, and for good measure Christopher Cox, chairman of the SEC, announced a ban on naked short-selling.

However, by Wednesday the tide began to turn. Oil slid further and a trio of better-than-expected earnings figures from US regional banks, including Wells Fargo, gave financial stocks a much-needed boost, with the financial sector jumping 12.3%. Oil prices slid to a low of $132 per barrel after a government report showed US supplies of oil had increased.

The feel good factor overflowed into Thursday with markets buoyed by more positive news from regional banks and a further fall in oil prices to below $130pb - a fall of some 12% from its peak earlier in the week.

Friday was less febrile with investors not sure they could cope with any more drama, but it was clear that those traders who had shorted [sold] financials and gone long [bought] on oil had been punished severely.

Needless to say, the excitement on Wall Street rippled across global markets, enabling most major indices to register decent gains on the week - in London the market advanced almost 2% to 5350 having briefly touched 5080 earlier in the week.

A Rare Winner

The imbroglio surrounding the banking sector has caused many casualties since the advent of the credit crunch last year, but for one bank it has created significant opportunity.

Last week, Spain's Banco Santander swooped in on Alliance & Leicester with a £1.3 billion offer the ailing bank couldn't refuse - a bold move when one considers Santander's home market is crumbling fast. Yet the Spanish bank has escaped fairly unscathed - it has no appreciable investment-banking business and has steadily reduced its reliance on its home market, added to which it has €6bn set aside for delinquencies that haven't happened yet, according to The Sunday Times.

In stark contrast, two of the UK's largest banks were struggling last week to find buyers for their rights issue stock - albeit already underwritten.

In fact, the weakened state of the banking sector is being cited by some observers as one of the reasons the Chancellor announced for putting the government's golden rule "under review" so as to allow a possible rescue operation for the banking system.

The Times was more caustic, saying rapidly worsening state finances - caused by falling revenues and overspending - had fuelled public borrowing to levels not seen since the end of the Second World War. News that net Government borrowing over the past quarter - the first of this financial year - leapt to £24.7 billion, up some two-thirds for the same period last year, shocked economists.

Yet there was some good news last week. The Independent reported that International Monetary Fund (IMF) has raised its global economic forecast for this year and 2009 because the effects of the credit crisis were not as bad as expected. The IMF now expects the global economy to grow by 4.1% this year and 3.9% next year - albeit lower than the 5% recorded in 2007.

There was some support for this view in the eurozone where Jean-Claude Trichet, president of the European Central Bank, said the region would avoid a severe downturn and expects to see "progressive return to ongoing moderate growth" in the last quarter of the year.

The IMF also expects UK growth to be higher at 1.8% this year and just slightly less for next year. If right it means that Britain might avoid a technical recession - two successive quarters of negative growth - and helped boost stock market sentiment.

Lean Into The Wind

With global stock markets caught up in the storm created by the credit crunch it is unsurprising that investors don't like what they see on the investment horizon and have been increasingly sitting on cash.

However, market gyrations are nothing new, as The Sunday Telegraph pointed out, and the ability to ride out bear markets is a key trait that ensures investors get rewarded and why there is an equity-risk premium. The paper opined that a substantial number of investors capture sub-market returns simply because they get squeezed out and then re-enter when prices are higher. No-one is going to sell assets at a discount when good news abounds - hence the old maxim "lean into the wind". The chances of timing your way in and out of the market at tops and bottoms is minimal so having a balanced portfolio from outset is the key, making sure you diversify your assets.

The Sunday Times came up with twenty reasons why investors should stick with shares - even though the last ten years have been difficult.

The paper highlighted the importance of dividends both from a re-investment perspective and income - the UK market currently yields around 4.5% (net) and historically dividend growth has outstripped inflation.

The paper also reminded its readers that some managers can beat the market, naming the likes of Andrew Green of GAM, Hugh Young of Aberdeen and Neil Woodford of Invesco as people to stick with through thick and thin. All manage funds for St. James's Place.

Another tip was to buy at times of maximum pessimism when shares are cheap - today the UK market trades on a price-earnings ratio of 10 - the average has been 17 over the last twenty years - with some sectors on even lower ratings.

For those with a lower risk appetite, The Sunday Telegraph suggested Corporate Bonds offer opportunity, as experts believe the gloom on this asset class to be overdone. Whilst returns are not guaranteed and inflation is a headwind, the paper highlighted the fact that many bonds trade on yields in excess of 7% which beats cash, and good managers can add value. One management team mentioned was Paul Causer and Paul Reid of Invesco Perpetual who are colleagues of Neil Woodford and manage our own Corporate Bond Fund.

A Silver Lining

One of the UK's most successful investment professionals is Neil Woodford of Invesco Perpetual, who is well known for his cautious outlook for the UK economy and which has been reflected in his more defensively positioned portfolio.

"I've been cautious for three years now and whilst I was premature in my outlook, the events of the last year with the advent of the credit crunch have vindicated my views. There are two main problems we face: an overvalued housing market and an over-indebted consumer giving the potential for a nasty correction."

"As to timeframe, well it really depends on the banking system and how soon the banks start lending again, which is clearly something the Bank of England wants them to do sooner, rather than later. The sector's efforts at raising extra cash via rights issues has not gone smoothly and further deteriorating markets makes raising capital harder. So I see the consumer being squeezed by falling asset prices and rising household expenditure and although the BoE would probably like to cut interest rates I don't see them budging until inflation is under control, which is likely to be next year."

"Against this very difficult backdrop there is fortunately a silver lining in my opinion. This is absolutely the wrong time to despair and sell equities. For various reasons institutional investors, such as pension funds, are selling their equities, just like they did back in 2001-02 and again at the wrong time."

"UK equities are the cheapest asset class compared to fixed-interest and property - even cash because this will not be inflation-proofed - and against European equities too. So this is a great time to invest although it may not seem like it. I know that in three to five years time we will have made a lot of money, so people should not get out of equities now - it would be the worst possible time."

"You only need to look at the facts to support my views and the long-term case. Back in the 1960s, equities used to yield more than bonds [fixed-interest] because of the risk element but then there was a cross-over and equities yielded less than bonds."

"Today we have a situation where many stocks yield more than Government stock - for example BP yields 5% [net] and trades on a price-earnings ratio of six (which is very low) yet its profits are going up. The market is taking a very pessimistic view short-term, but my experience tells me that when equities feel awful you should buy."

"Investing is not scientific - I can't tell you when the market will hit bottom: it may already have done so. My job is to protect investors' capital over the medium to long-term in real terms and all I can say is that I am confident now is the time to invest. Because I believe the global economy will enjoy better growth than the UK, I am investing in companies where any UK recession will have minimal effect. 70% of UK corporate earnings come from overseas so there is plenty of choice."

"So in the portfolio I am avoiding the consumer and instead focusing on the oil majors, utilities, pharmaceutical and tobacco companies. I think the oil price will stay high because of demand pressures and there is a strong argument for gas which is a cleaner form of energy, so Shell, BG and BP are in the portfolio."

"I am pursuing the renewable/sustainable energy theme by owning British Energy, Drax and Scottish & Southern Electricity. Energy companies are cheap, with their asset values more than their market capitalisation. The utility sector is not vulnerable to recession and the companies involved are low risk growth businesses."

"Similarly I take the view that drug companies will sail through recession - their products are needed not by just developed countries, but increasingly in the future, developing economies too."

"So right here and now, with share prices crushed, there are some great opportunities out there and with little risk in my view, meaning I can buy low and sell high which is what it's all about."

21 July 2008



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