The pendulum never stops half way
Are we going to see a double-dip recession? Will deflation hit? Surely the equity markets can’t get much worse, with the US and UK indices nearly halving (not to mention Germany which has gone down by nearly 75%)? After all, how sustainable is a situation where the dividend yield on many equities is higher than long term gilt yields?
Yes, shares are starting to look quite attractively priced on a yield basis. But before piling in, investors should consider whether dividend levels are in fact sustainable, given that corporate profitability seems to be under so much threat.
The warning signs on the deflation front just appear too compelling to ignore. Deutsche Telekom has just reported the biggest loss in German corporate history. Many other international companies have started on a path of negative earnings ‘growth’. Retailers have no pricing power, and post-Christmas sales in the northern hemisphere (that actually started before Christmas in many cases) are soon being replaced by spring promotions.
After a bubble, ‘attractive’ share prices are just not good enough. Just as the market lost all sense of reality on the way up, it is now also more than likely to do exactly the same again – in the opposite direction. The pendulum never stops half-way.
Ultimately, there won’t be any bulls left. And when everyone capitulates, the market will form a bottom. By definition, the time of greatest despair will prove to have been the best ever buying opportunity. It will however be exceptionally difficult for each and every one of us to realise when that moment has in fact arrived, as we’re all only human, and we’re therefore likely to suffer from a healthy dose of despair ourselves.
We are nowhere near those capitulation levels yet. There are still way too many analysts trying to call the bottom of the market on a daily basis.
Many other warning signs remain. The American consumer – who until recently seemed to enjoy the ignorant bliss of a real estate bubble financed by a debt bubble – seems to be finally giving in. At last they seem to be spending less, probably because many of them are worried about lower share prices; companies that might have sold product to them will suffer in the process; these economic woes are then discounted in the market in the form of even lower stock prices. We are only in the early part of such a self-fulfilling cycle.The truth is that a bubble which needs to unwind fully against a background of weak economic fundamentals and dubious company balance sheets cannot be blamed on Saddam Hussein.
In spite of all their pessimism, one has to consider that even the strongest bear markets are characterised by some fairly significant rallies. And chances are that we’re due for at least a short and sharp (war-related?) one in the next month or two. Investors will utilise such a bounce in one of two ways: either to rationalise a bullish stance, or as a selling opportunity.
Insurers worldwide have been forced to sell equities in order to bolster solvency ratios and pay claims. Pension fund trustees are starting to wonder about strategic asset allocations, with more than half of their funds invested in an asset class that has been performing poorly. Retail investors have stopped investing in mutual funds.
Are these not signs of capitulation? They certainly are. But capitulation is a process, not a moment. And markets don’t turn instantaneously.
We are, by definition, certainly a lot closer to the bottom than at any other time in the last few years. However, an equity investment made today is likely to take a very long time to show a reasonable return.
There are many reasons why people will not agree. Specifically within the world of investment professionals, people are generally tired of the sceptics and the nay-sayers. The collective self-interest of stockbrokers and portfolio managers is what drives them on, and bull markets are needed for bigger bonuses.
Based on this, bears are used to being in the minority. But watch out: it’s when these perpetual bulls start agreeing with us, that we’ll consider changing our mind – for that will be a sure sign that real capitulation is finally setting in.So where should pension funds invest in such an environment? If deflation really hits, corporate bonds will suffer in line with equities, and even cash will stop producing returns. Which leaves government bonds: with a guaranteed coupon, and possible capital gains as interest rates go even lower, these asset classes may have some legs yet.
Deon Gouws is chief investment officer at io investors in London