Psychology still driving markets
Our basic macroeconomic scenario is that this cycle is not different from any other typical business cycle in the past. We think that the global economic recovery will unfold at the end of 2002 and in 2003, driven by a rebuilding of inventories and followed by a cautious increase in capital spending.
Monetary easing is still effective and we expect both the Fed and the ECB to continue their current policy for this cycle. Labour markets have not collapsed up until now, real income at consumer level is still steady to rising while some positive signs are finally emerging at a corporate level as well.
It seems, however, that the macroeconomic environment and prospects did not really matter for equity markets until recently. We have seen a relatively mild recession, central banks have been in a serious easing mode, tax burdens have been lowered, but equities nosedived and were heading for a bear market with a similar length as that of the bear market at the beginning of the 1930s.
Apparently, distrust about equities as an asset class seemed more of a driving force than anything else. It is psychology rather than economy that drove equity markets. Moreover, European pension funds and insurance companies were reaching the limits set by their financial obligations towards policy holders and employees, present and past. This had allegedly forced some of them to liquidate part of their equity holdings, setting in motion a negative spiral.
For years and years institutional investors in Europe have been a permanent source of demand for financial assets, but now they are at best waiting at the sidelines.
It is fair to say that financial markets have already come a long way in discounting a sub-par economic environment over the next few years. Bond yields are at 40-year lows in the US, while valuation levels in equity markets have substantially come down from there pre-bubble levels. From this viewpoint allocating money between bonds and stocks should be fairly simple: what is so appealing about 10-year Treasury notes at 4% based on a medium-term horizon?
If one assumes a GDP to return to trend growth in 2003, fueling top-line earnings growth against a background of massive cost-cutting measures and restructuring in corporate America, fairly priced stocks which return a nice dividend to the shareholder should be preferred to government bonds.
The question, however, is how long the negative market psychology will continue to dominate. Even after October 9, when equity markets started a rally, many people still talk about “a rally in a bear market”. Conditions for a market bottom are a profoundly negative sentiment, reasonable to low valuation levels, and the prospect of economic recovery. Market sentiment still is quite negative. A positive factor is that seasonal patterns favour a higher market in the next three to six months.
Regarding valuations it is clear that earnings/yield ratios indicate that stocks are very attractive from a relative value point of view. On the other hand market valuations are not compellingly low in terms of traditional measures such as price-to-earnings and price-to sales ratios.
By continuing to be overweight in equities we take the view that equities will move higher during the remainder of the year and the first three to six months of next year as economic recovery will regain speed in late 2002 and the beginning of 2003. This will pave the way for an improvement in corporate earnings.
In addition, the relative valuation of stocks versus bonds still strongly supports our longer-term preference for equities against bonds. In our sector and regional equity allocations we do not want to take strong bets at this points in time as we want to wait and see which forms of leadership will develop during a fall rally.
We recently reduced Japan to an underweight position for economic as well as seasonal reasons in favour of the US. We maintain our overweight position in emerging markets as this asset category will strongly benefit from a global economic recovery.
Bas Vliegenthart is the senior executive vice president at Robeco Asset Management in Rotterdam