Amid the growing debate about the outlook for equities and bonds and the world’s growing search for yield (do “equities live” as we noted earlier?), here are the latest views from two seasoned market watchers and analysts – Andrew Smithers, of Smithers & Co, and Marc “Dr Doom” Faber, who seems to have taken to the blogosphere recently with a rather sparse but free blog (the latest insights of which, include a ringing endorsement of big-cap US tech stocks a la Intel, Microsoft, Google, Apple and Oracle).
Smithers has just published a client report on world market values in which he notes that:
(i) The world market in aggregate, at the end of January, was around 38 per cent below fair value, (ii) that the US is relatively expensive, being around fair value and (iii) that Japan is the cheapest market.
But “cheap” as we all know doesn’t necessarily mean “good value”. While noting that value is of little use in forecasting short-term market movements, Smithers says his conclusions are encouraging, “because in bad times – and these are bad times – markets usually become decidedly cheap”.
World stockmarkets as a whole were around 38% underpriced at the end of January 2009. Another 21% fall would bring share prices to the level of undervaluation reached in 1957 and similar years, although a further fall of 54% would be needed to get markets back to the extreme cheapness of 1948. While we emphasise that value is little guide to short-term market movements, we think that it is encouraging that the world needs to fall by only another 21% to reach levels which could reasonably be called typical of past very cheap markets.
Overall, Smithers remains bearish about the outlook for equities for 2009, mainly because demand for shares by companies is falling and their supply rising as both financial and non-financial companies change from buying shares to issuing them.
In fixed income, meanwhile, government bonds are expensive, and are likely to remain so for a while as the world economy continues to weaken.
However, the short-term outlook for corporate bonds seems quite good, notes Smithers. With the exception of the recent slump, the spreads on US corporate bonds are at record levels and have been narrowing since the beginning of 2009. However, this narrowing of spreads has been accompanied by a fall in corporate bond prices, due to the fact that government bond yields have risen by more than spreads have narrowed.
Consider the three main factors determining their yields, he says:
(i) Government bond yields, which we expect to be flat short-term and to rise in the medium-term, (ii) the default risks, including default experience, variations in default expectations, (iii) the variations in the return to investors for buying relatively illiquid assets.
In the shorter term, the return on corporate bonds should be good, in Smither’s view, “unless the downgrading of bonds, default experience and the default premia have an offsetting negative impact”. While it’s true that US companies are more highly leveraged than is still generally appreciated, the relatively low level of interest rates mitigates this risk.
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Faber, meanwhile, predicted in a recent client newsletter at the end of January that the stock market’s immediate response to US stimulus measures would be to rally further for several reasons – not least the hope that, in some cases, there will be a modest improvement in the relentlessly bleak economic and financial news. By “modest improvement”, though, he means news will merely be less horribly negative than it is now – and when that happens, “eternally bullish fund managers” will undoubtedly take it as a sign of a recovery in the second half of 2009.
There are two other indicators suggesting a positive view may be justified, even if only for the moment, says Faber. First, that the market remains physically oversold:
The appalling economic news has encouraged traders to stay short – for example, as recently as mid-January, the 5-day average of put-call ratios on equities was only a little below the extremes of last November – but the equity indices had not given up much further ground.
Second, he says, that there has only been one case since 1900 where the DJIA has fallen by significantly more than 50% during a bear phase.
This was in 1930-32, when it fell by 86%. But the point here is that the preceding 1929 Crash embraced a fall of 48%, and was then followed by a significant rally of about 50%.
In the current bear [to end-January], the DJIA has fallen by 48%. At the very least, a bear squeeze should be in the making.
Faber also quotes Joachim Fels, Morgan Stanley’s chief global fixed income economist, noting that the liquidity cycle has turned up. According to Fels:As GDP downgrades abound and investors’ gloom thickens, our metrics indicate that a new global liquidity cycle is in the making. While still in its infancy, this new liquidity cycle will likely help support asset markets, end the recession later this year and prevent lasting deflation. As always, it is difficult to predict which asset classes will benefit most from the build-up of excess liquidity. However, our strategists favour credit and EM equities in 2009.
Fels adds:
“Focus on global excess liquidity… Our favourite metric for tracking the liquidity cycle remains the evolution of excess liquidity, which we define as the ratio of money supply M1 to nominal GDP (aka the ‘Marshallian K’). M1 is a narrow monetary aggregate comprising currency in circulation and overnight bank deposits held by non-banks. It is used for transactions in the real economy – when buying goods and services – and in the financial sphere – buying stocks, bonds or other financial assets.
Of course, as Fels notes, “it is difficult to predict which asset classes will benefit most from the build-up of excess liquidity”.
But that certainly doesn’t stop the veteran pundits from trying – and even, sometimes, succeeding.
Related links:
Equities live! – FT Alphaville
The death of equity – FT Alphaville
Extreme corporate credit bulls – FT Alphaville
Life insurers: terrible bond investors – FT Alphaville