Think Big
We received a healthy amount of pushback on our call from mid-August to start buying equities again. Pushback is good. We know that we may well be on the right track with a call, when we get a lot of investor pushback. It means we are not consensual. Six to twelve months later, with the benefit of hindsight, we know we will look very silly or very right. We see 12% upside to our 12-month target of 1750 on MSCI Europe,and we recommend investors start building positions now, as it is possible that there will not be a better entry point.
Our bull case, overshoot-type scenario, implies 21% upside from here. Since the market troughed on August 16, MSCI Europe is now up 7.7%. Our preferred sectors are Tech & Telcos, Healthcare, Financials. Our least preferred are Consumer-related areas.
Building the base for a mania? There are many risks at the moment. But imagine that we get through this financial turmoil,and an uptrend in equities resumes, as we expect. In this piece we describe why we think that will be the case. If we are right, then equities could be set for a big, big rally. Bulls will say that this uptrend is unbreakable, after all the trouble that has been thrown at it. “The cycle is dead”, and “this time it’s different” will be heard all over the place. Emerging markets will be seen as the new growth engine that cannot be derailed.
This final leg of the bull market will be characterized by all the things we have not seen yet this decade, including big retail buying of equities, big strategic M&A, an increase in corporate confidence leading to a capex boom and multiple expansion in equity markets. There would also be a real mania in certain concept stocks,probably mostly in those related to commodities, infrastructure and emerging markets. Remember that it was only after the 1998 correction that the likes of Nokia and Ericsson went to 70 times PE multiples.
Of course, it won’t be different this time,and as always it will all end in tears, eventually, probably when higher inflation and rates lead to the next recession. But if we get through the current financial crisis, it is highly likely that the next phase in equities is a mania of epic proportions.
It is of course possible that we have not seen the trough in this correction yet. There are many uncertainties around, and markets do not like uncertainties. The money and credit market problems are very serious. More financial losses will be uncovered. Large parts of the credit and money markets are dysfunctional. Suddenly investors have to familiarize themselves with concepts such as SIVs and ABCPs. This decade’s bull market has been built, to a large extent, on an appetite for debt and structured products, and that appetite has certainly peaked for years to come. The Anglo-Saxon consumer is likely to be weak in the coming 1-2 years. With so much uncertainty around, it is even more difficult than usual to tell what the future will hold. In 1987 and 1998, two previous periods of severe financial crisis which turned out to be bull market corrections, not the start of recessions, there were double-bottoms in equity markets, and several Fed rate cuts were needed to stabilize markets. In such a bear case scenario, MSCI Europe could fall by some 17% from here, in order to reach crisis valuation levels of -2 standard deviation cheap on our CVI. See Finding the Trough, August 20, for more detail behind our scenario analysis. This suggests that the price of a wait-and-see-approach to today’s market may not be that high, and wait-and-see is indeed what most investors are doing.
Wait-and-see may indeed be sensible and prudent, but everyone is doing it. The virtually unanimous mantra among investors is: “I am not going to take big risks now. I would like to wait a few weeks to see investment banks report (week of September 17), the Fed act (next FOMC on September 18),and to see the next batch of economic data before committing more money one way or the other (eg, US CPI on September 19).” Even the bulls, those that are convinced that the market will be higher 12 months from now because they think the economic growth outlook outside the US is good and the US slowdown will not be big enough to derail this outlook, even they see no hurry to buy. This wait-and-see approach is quite understandable. Focusing on capital preservation in periods ofuncertainty is prudent and sensible. Especially if you are lucky enough to be sitting on good gains for the year, sitting tight and waiting is undoubtedly a prudent and wise thing to do. But the problem with the wait-and-see approach is that everyone is doing it, and this consensual attitude may well prove to be a mistake.
As a result, there is a good chance that equity markets have already troughed and will not offer a better buying
opportunity. In bull market corrections you should buy early and sell late. The very fact that everyone is waiting and seeing,increases the chance that we have already seen the equity market trough on August 16, in our view. On the one hand, the biggest pain trade is undoubtedly for markets to keep tanking and to go down by 50% from here. However, a pain trade that would catch market participants off-guard is that there will not be a better buying opportunity, and that the market edges higher day by day, and enters its mania phase next. Two months from now, suddenly, investors would need to scramble back in, having missed the first 10%. Exhibit 13 shows the history of bull market corrections. It is interesting to note that the biggest intra-correction rally has been 6.2% in the 1987 correction. Therefore, the fact that between August 16 and September 4 the market rallied by 7.7% also increases the likelihood that we will not go to new lows in this correction, we think.
The bearish extreme: equities will be down more than 50% in the next recession! Timing of that next recession is everything, but it will be horrible. We estimate that if the recession starts today, equities could go down as much as 70%. This is because in such an environment ROE will go from its current high of 17% to trough level of 8%. This implies that earnings will approximately halve if book value stays constant. Furthermore, at the end of severe bear markets, the PE multiple often has reached around 10, compared to its current level of 14. This combination implies up to 70% downside. We don’t think this is a very likely outcome in the next 1 or 2 years, as we discuss further on. We do think, however, that of three scenarios: mania, recession, or muddle-through, the muddle-through scenario is the least likely.
We recommend investors start buying equities. The scenario we think is most likely is that this is a bull market correction, and that markets will go to new highs before this bull market finishes. Since mid-August, equities is our preferred asset class, whereas during the months before that cash had been our preferred asset class. We believe that the fallout of the financial crisis will be a US economic slowdown, but as long as growth is positive, mid-cycle slowdowns are bullish for equities, as the positive impact of lower rates is more important than the negative impact of lower growth.
Let’s analyse how we get to that conclusion, using the three pillars in our approach: valuations, sentiment, fundamentals.
Continued…
