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Saturday, March 1, 2008
Avoid the bombed out parts

Is the bear market underway? - It depends on which market you are talking about

The debate starts whenever the market undergoes a sizeable correction: “Has the bear market begun?”
This question is relevant because bear markets, which tend to coincide with economic and profit contractions, are usually drawn-out affairs playing out over several months - if not years - and are different to short, sharp corrections that recover in a matter of weeks.
Explains Shaun le Roux of Alphen Asset Management, “A classic bear market relentlessly wears down the optimism of even the most steadfast bulls, to the point where they can no longer take it and eventually throw in the towel. At its lows a bear market sees stocks trading at extremely cheap levels.
“For example, in the most recent bear market on the JSE to speak of, in 2003, the All Share Index was trading on a price-earnings (PE) ratio of under nine (versus 14.4 at the moment) and a dividend yield in excess of 4% (versus 2.6% at present).” In fact, during the 1970s and 1980s, single digit PEs and 5% plus dividend yields were the order of the day. After the strong equity bull market of recent years, there is a school of thought that feels that stock valuations need to approach those prevalent in past bear markets before it is worth buying.
“This having been said, we caution investors against taking a singular view on the whole South African stock market, because it is important to note that it does not comprise a set of homogenous companies with the same drivers.”
Just like Thabo Mbeki speaks about South Africa’s two economies, the JSE can be split into two camps: those shares that are driven by the global economy and those that are focused on the domestic economy. We estimate the split at roughly 60% global to 40% local for the JSE All Share.
For obvious reasons, the JSE global shares tend to follow global stock markets and the global economy closely, and though everyone is currently intently watching the US economy, as things stand the bull market is still intact for these shares. This part of our market is dominated by commodity shares and they continue to be supported by strong demand for raw materials out of China, high precious metal prices and more recently a weaker rand. The shares are much cheaper than they were late last year but are nowhere near bear market levels.
The JSE domestic shares started falling earlier and saw their prices much harder hit in 2007 and early 2008. In fact, domestic shares have been in a cyclical bear market since around May 2007. The combination of rate hikes and the resulting consumer slowdown has seen foreigners heading for the exits and to date local appetite remains muted. This is understandable given the very tough trading conditions of the last quarter of 2007, which have deteriorated into 2008 and been exacerbated by the ongoing Eskom debacle.
Mr Le Roux notes that investor sentiment is very poor as far as domestic companies are concerned at present. However, history has shown that the best buying opportunities are always found in the depths of despair and the good news is that the valuations of many of the domestic stocks are starting to reach those bear market levels that are indicative of the bulls throwing in the towel.
“Your main call on whether domestic stocks offer value or not, is whether you see a slowdown in their rate of growth or a contraction in their earnings. In the case of a contraction, earnings go backwards and dividends get cut - a situation which we believe domestic stocks are starting to price in,” he says.
During 2007 the baton of responsibility for driving the SA economy forward was passed from consumer to investment spending, which bodes well for the sustainability of domestic economic growth and hence the medium-term prospects for domestic stocks. Also, we are of the view that the step-up in domestic consumption over recent years has been mainly structural in nature, on the back of a permanent reduction in inflation (and interest rates), though we are experiencing a short-term spike in consumer inflation.
“Over the long-term, the consumption base of the economy will be supported by the introduction of a significant market that had previously been shut out, the black middle class,” comments Mr Le Roux. “Hence, we do not see a significant broad-based contraction in profits for domestic stocks, though the next year will certainly see a sharp slowing in the rate of growth. In some cases earnings will go backwards, as demonstrated by the likes of JD Group and Imperial, though we expect this to be largely confined to the credit and motor vehicle retail sectors.”
Broadly, we view current prices as presenting attractive buying opportunities but, the sell-off in the rand does raise the risk that interest rates may need to be hiked further, which will delay the improvement in fortunes for locally-focused shares.
“If you see value in domestic stocks, when should you start to buy? We constantly warn against trying to time the market, it is worth pointing out that history has shown that domestic rate-sensitive shares tend to outperform by some margin after the last hike in rates,” he says. “We would like to think that local interest rates have peaked, but acknowledge that the current pressure on inflation and the recent slump in the rand does pose a risk to this view.”
In market conditions like the present we are firmly in the camp of preferring value stocks. These are stocks that are pricing-in an excessive amount of bad news, where low PE ratios and high dividend yields point to the most attractive price levels in five years and where we perceive an attractive margin of safety on a two- to three-year view.
As we have argued, the domestic shares consequently offer the most attractive opportunities and we thus continue to tilt our portfolios to the better quality bombed-out parts of this market.

Copyright © Insurance Times and Investments® Vol:21.2 1st March, 2008
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