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Sunday, March 1, 2009
A cold start to 2009

The ‘January barometer’, which states that as January goes for equity markets, so goes the year, has an excellent long term record. But if it is valid for this year, then investors would appear to be in for another poor year. The S&P 500 Index returned nearly -8.4% in January and the MSCI World Index -8.7% in dollars, representing just about the worst start to the year on record. The Dow Jones Index performance of -17.5% between Election Day on November 3rd and Inauguration day on January 20th was the worst on record.

“Amongst the investment community, the sense of crisis last autumn has given way to relentless gloom,” laments Max King, Strategist and Portfolio Manager, Investec Asset Management.
“A rapid succession of fiscal, monetary and financial packages is leading to increasing cynicism; they aren’t working, they can’t work or they have political rather than economic objectives. Those who acknowledge market upside see it as only a bear market rally. The prevailing view on the outlook for economies and corporate earnings is catastrophically bearish, expecting depression rather than recession, and permanent rather than temporary falls in profits.”
Yet on closer inspection, the omens are more mixed. The January barometer has a surprising twist in its tail: the S&P 500 Index actually rose in the 11 months following each of the five worst Januarys on record (1939, 1960, 1970, 1978 and 1990). Perhaps the omens for the rest of 2009 might not be so bad. The second worst Dow Jones performance between election and inauguration was the 16.7% fall following Roosevelt’s election in 1932. In the following year, the index doubled. Despite another panic in the banking sector, markets have held above their November lows, market breadth is improving and volatility is beginning to fade. The impetus to drive markets higher may not be there yet, but the risk of new lows is also diminishing.

Buying opportunity or bear market rally

The risk of new lows will remain until there is evidence of economic green shoots in the US and of a reduction in the downward momentum of earnings. What we can say with increasing certainty is that such a setback should represent a once in a generation buying opportunity - so much so that it may not be worth the risk of missing out by waiting for a setback that probably won’t happen. “In the middle of last year, we said that the outlook for equities over the next 10 years was excellent, but that there was a good chance that the first steps would be backwards. Now, the prospects are better and the odds of starting in reverse gear are much fewer,” he observes.
This view has received powerful support from the annual Barclays Equity Gilt Study, written by the highly-regarded Tim Bond. He points out that equity returns over the past decade have been among the worst on record. In the US market it was the fourth worst decade in the last 83 years, returning -0.3% annualised, and only the decades ending in 1937, 1938 and 1939 were worse. In the UK, the 10 year return of 1.05% was slightly ahead of the 1964-74 return of 1.02%, which was the worst 10 year return for the UK market in the last 110 years. By the late 1990s, the Barclays model, based on long term metrics, was projecting negative returns for US equities over the next 10 years for the first time since the model’s inception in 1935 – exactly as has happened. Over the next 10 years, the model projects an annual return of 12%, enough to make a portfolio more than treble in value.
Mr Bond dismisses the notion, currently gaining ground, that poor returns are the result of an intrinsic problem with equities. Rather, they are attributable to extreme overvaluation at the start of the decade. This was brutally corrected in the 2000-2003 bear market, yet still left valuations high relative to both cyclically adjusted earnings and replacement cost. In the 2003-2007 bull market, share prices were driven entirely by earnings growth, with valuations continuing to fall. Since 2007, both earnings and valuations have fallen, finally reaching levels that are undervalued by the standards of the last 100 years and cheap by post-war standards, especially when the low level of inflation is taken into account.
He also rejects the idea that soaring markets in the late 1990s were the result of “irrational exuberance.” Instead, it was the result of two factors; firstly macro-economic volatility declined as inflation fell and growth became steady, and secondly demographic trends were favourable. Declining volatility encouraged excess risk taking, particularly in the form of leverage, which eventually made the supply of credit, markets and economies vulnerable to a relatively modest tightening of monetary policy. Demographic factors, particularly the high savings rate of the baby boomer generation, help explain rising bond and equity valuations in the 1990s but now point to higher bond yields as the same baby boomers retire (equity earnings yields, the inverse of the p/e ratio, having already risen). The Barclays model points to yields on government bonds soaring in the next few years.

What now for investors looking at equities versus bonds?

“This is not a problem for equity markets for this simple reason – it is already discounted,” King announces.
An historic yield on the MSCI World index of 4% is compatible with a 10 year government bond yield in double figures while future economic growth, a recovery in profits and, hopefully, a switch from share-buybacks to dividends suggest that dividend growth over the next 10 years will be good.
In the UK, growth in the All Share yield of 4.75% should also be helped by the devaluation of Sterling and the eventual return of dividends in the banking sector. For investors in government bonds, however, soaring bond yields would threaten disaster. Yields reached record lows at the end of 2008 but have since risen sharply; by 0.8% in the US, 0.7% in the UK and 0.4% in Germany. The consensus view has been bearish, which is unsurprising given the miserable yields on offer at the start of the year and both the reckless abandon with which central banks are conducting monetary policy and governments are planning budget deficits.
“Curiously,” says King, “appreciation of this consensus may be making investors complacent: they distrust a view that is so obvious that everyone agrees with it. To follow both common sense and rational analysis would be to continue to avoid government bonds. The high spreads of corporate bond yields over government yields offers a significant degree of protection, but it would be sensible not to be complacent. Corporate bonds are very attractive relative to government bonds and, for now, are attractive in absolute terms, but equities look more so, and should outperform in the longer term.”
Despite the prevailing gloom, 2009 is increasingly unlikely to be a poor year for equity markets: it may be a dull year – though we doubt it – but it looks very likely to be the start of an excellent ten years, says King.

Copyright © Insurance Times and Investments® Vol:22.3 1st March, 2009
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