2001 will go down as one of the blackest years in the history of equities. The Swiss stock market was no exception, with the SPI losing around 20% – post-1925, only 1931, 1962, 1974, 1987 and 1990 have been worse. As things stand, weakness on equity markets worldwide can be blamed primarily on the collapse in profits produced by plunging global demand, overcapacity and the unexpected drop into recession of the world’s most important economy, the US.
But global factors weren’t the only ones keeping the lid on the financial markets – company-specific considerations also had a role to play, as demonstrated in Switzerland by ABB, Swissair and Zurich. In the US, the downfall of energy trader Enron was the biggest insolvency case in US economic history.
In addition to questions about corporate governance in general, the Enron collapse also raised issues about the role of audit firms. Evidently, with their assistance, it had been possible to disguise losses for many years, possibly even presenting them as profits. The ‘creative accounting’ practices of other US companies have since come to light – this at an especially bad time in which corporate earnings trends are shrouded in uncertainty anyway. There was much discussion last year, in particular, about reported earnings in the US being inflated artificially by executive share options. There is dispute as to whether profits should be viewed in terms of operating earnings (ie, profits not including non-recurring special write-downs) or as reported earnings in calculating the various key financials. Finally, the conversion to US-GAAP accounting as of 30 June 2001 means that goodwill amortisation is now treated differently. Under the old rules, goodwill had to be written down regularly on a straight-line basis. This method had a predictable and quantifiable impact on earnings. Now, however, goodwill is amortised only if its ‘fair’ value is less than its book value. This is checked annually. The new approach tends to produce higher earnings and thus lower multiples.
From the investor’s point of view, then, there is considerable uncertainty attached to earnings, be they expected or historic. But they still form the foundation for many calculations, such as P/E (the price/earnings ratio), fair company value or risk premiums. We nonetheless believe conditions on the equity markets to be more favourable than they were a year ago.
In the meantime, we have seen the US Federal Reserve slash its interest rates by a grand total of 4.5 percentage points. The effects of these cuts have yet to be felt. Companies have grasped that the sales and earnings growth rates of the 1990s are a thing of the past, at least for now, and 2001 was devoted to restructuring and massive downsizing. Should the global economy (with the exception of Japan) improve slightly, as we expect, companies will be able to meet at least stable demand with much leaner structures and a lower cost base than last year. Higher earnings for this year would be the inevitable result. This explains why analysts’ 2002 earnings forecasts are predicting anything between stability and a 13% rise for the US equity market, having shrunk by something like 20% in 2001. The outlook for the equity markets is brighter than it has been for some time.
There is no question that risks remain, however. Despite corrections, the US equity market does not yet offer genuine value, there will be no more sustained falls in interest rates, and the global political climate as a whole is still tense.
Should the expectations described above be met, we can definitely look forward to a return to positive, single-digit returns on the markets – a view backed up by the statistics.
We are weighted to market on equities, but have overweighted bonds in the light of the balance between risk and return. We favour the US stock market ahead of the UK and Europe, and are avoiding Japan. Our sector allocation is still biased towards cyclicals such as raw materials, industrials, consumer cyclicals and telecoms. Despite its rather defensive nature, we have reweighted energy to neutral on the basis of positive earnings revisions. Financials – and insurers in particular – remain underweighted.
Thomas Steinemann is chief investment offficer of Vontobel Asset Management in Zurich

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