Global equity markets are behaving irrationally
The sharp falls in global markets over the last month are due to more excessive fear and herd behaviour than any shift in economic and corporate fundamentals. Since their highs in July global stock markets have fallen by more than 20%, driven by a swathe of negative economic data, growing anxiety over sovereign debt and the after-effects of a US rating downgrade. Despite the sharp falls in equity markets, nothing much has changed over the last few weeks. After losing their prized AAA rating, US treasuries still remains a safe haven asset, this is reaffirmed by Moody’s and Fitch commitment to maintain their AAA rating. Anxiety over sovereign debt has been present since 2008 and weak economic data only confirms that economic recoveries following balance sheet recessions are typically slow and protracted. There have been no new significant economic developments that would justify such a dramatic fall in global equity markets in the last few weeks. In my view the markets are now tremendously undervalued, there are three reasons for this.
Firstly in the midst of the recent market falls, economic and corporate fundamentals seem to have been forgotten. Share prices of the top 20 companies in the FTSE 100 (UKX) have fallen by more than 15% where as average forecast earnings have been downgraded by a modest reduction of 1.8% over the last month. Reductions in share prices have been nowhere near modest earnings falls, as a result there are now plenty more bargains available for investors looking to increase equity exposure. On the economic front the Federal Reserve’s survey of US banks senior lending officers last week showed a continued gradual easing in the conditions on which they make loans, the financial sector continues its ‘long hard slog’ to recovery. Purchasing manager’s surveys still suggest positive growth and demand for commodities remains robust. The market falls may be indicative of a slowdown, but a double-dip recession is unlikely and should it occur will be temporary given the growing presence of emerging consumers in countries like China and India. Also it is important not to read too much into the recent sell off because stock markets have had a terrible track record for predicting downturns, as the saying goes stockmarkets have predicted 10 out of the last 3 recessions.
Secondly markets are driven by the interaction of greed and fear. In this case when fear swamps greed, markets tumble. Panic selling, as is happening now is a great way to lose money by buying high and selling low. In these circumstances it is important to look at the two parts of the brain which govern decision making. The first is the rational and logical part most suited to long term goals, the other part controls emotional decision making. It is the latter part to which investors are using and are seeking instant gratification through panic selling; this has contributed to the sharp falls in global equity markets. It is worth invoking the wisdom of Warren Buffett “Be fearful when others are greedy, be greedy when others are fearful”. Markets in my opinion have fallen more the fundamentals would warrant and therefore present opportunities for contrarian investors looking to boost their exposure to the stock market.
Lastly is the widening yield gap, this is the difference between the average dividend yield in the market and average bond yields. This is a classic indicator to measure whether a stock market is over or undervalued. In normal situations equities yield less than bond yields, this is due to equities potential for superior capital growth and because they are a hedge against inflation. Today the FTSE 100 dividend yield is just below 4% where as the 10 year gilt yields below 3%. When the yield gap goes into reverse, it usually presents a buying opportunity for those with the courage to take it. I wouldn’t describe it as a ‘screaming buy’ but certainly a buying opportunity and one in which investors can apply the ‘buy in dips philosophy’.
This is not a repeat of the global financial crisis in 2008 but an aftershock and an overreaction. John Templeton, one of the great contrarian investors of the past century said “Invest at the point of maximum pessimism”, I agree. Those considering increasing their equity exposure can adopt a ‘drip-feeding strategy’ to take advantage of the unprecedented volatility. Head of research at Hargreaves Lansdown Mark Dampier writing in their monthly investment newsletter said “I believe the biggest threat comes not from the market but from the human tendency to stick ones head in the sand”, therefore I believe investors sitting on the fence would come to look at this as a missed opportunity.
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17 Comments on this Article show/hide all
Sorry, but this article sounds like complete bunk to me. Just because the market moves in the opposite direction to the author's wishes, he seems to conclude that it must be "irrational" and driven by "emotion" and "panic". An alternative interpretation would be that the author's investment thesis is completely wrong.
There are many significant economic developments that more than justify the falls we have seen. Remember that at the April stockmarket highs, the consensus was that the system was healing and that the recovery would continue. Since then
1. The US has lost its AAA rating from S&P. Not exactly a healthy sign, and one which could have unexpected consequences considering that the whole financial system is built around the assumption that US debt is risk free.
2. It is becoming ever clearer that the Eurozone crisis hasn't been solved, and that its resolution will be extremely unpleasant.
3. QE2 has ended. That means that hedge funds have less cash available to pump up the stock market to ludicrous levels.
4. The Western world has been in a balance sheet recession since the 2008 financial crisis. That means the usual pattern of post WWII recessions doesn't apply. Growth will be weaker, and recessions will be more frequent. Many market participants have been in denial about this, and are now waking up to reality.
5. Whilst some companies have been doing quite well, this isn't likely to continue for companies in general for a host of reasons. Firstly, many Governments have started austerity programmes, which are likely to reduce growth. Secondly, corporate balance sheets are quite highly leveraged. Thirdly, profit margins are at a historical high and are likely to revert to the mean. Fourthly, a lot of the improvement in earnings is due to cost-cutting, which can obviously only go so far.
6. It is becoming clearer that we are entering the second phase of the crisis, which will consist of a series of sovereign defaults by developed countries. Obviously this will have a seriously negative impact on company earnings.
7. Governments have fired all the fiscal bullets they can get away with politically. Central banks are at the zero bound, and QE has failed. They face political opposition to more exotic policy options, which are highly likely to backfire anyway. The Greenspan/Bernanke put is dead.
Other assorted thoughts:
*Analysts have such a terrible record in forecasting earnings, I hardly think it deserves a mention.
*Whilst lending conditions might have improved, credit growth in the US economy has been entirely due to the Fed's QE, which has just finished.
*The author asserts that a double dip recession is "unlikely". I would say that its almost certain given the factors already mentioned.
*The author ignores the ridiculous amount of over investment that has occured in China. How has he managed to convince himself that there's anything sustainable about China's economic model?
*It never ceases to amaze me how market bulls select the valuation metrics to suit their investment case without bothering to look into whether they actually make any sense. Comparing the dividend yield on shares with the gilt yield is a nonsense, and history has shown that it has no predictive value. The best valuation metric to Tobin's Q, and the second best one in the Shiller 10 year PE. These show that the stockmarket is actually greatly overvalued, even after the recent falls.
I agree that this isn't a repeat of the 2008 financial crisis - it will be worse. The real wonder is not how much the market has fallen recently, but how much it went up from the March 2009 low in the first place. In reality, is the opportunity of a lifetime to reduce risk exposure.
In reply to dodge1664, post #1
he seems to conclude that it must be "irrational" and driven by "emotion" and "panic". An alternative interpretation would be that the author's investment thesis is completely wrong.
In fairness to the original author the volatility indices are proving "panic" and "emotion" given their wild swings.
http://finance.yahoo.com/q/bc?s=^VIX&t=5d&l=on&z=l&q=l&c=
Whether the market is right or wrong is another matter entirely which I don't have a clue about.
In reply to nigelpm, post #2
I take your point, but volatility is always higher during market bear phases. We have seen Mr Market in bouts of both fear and greed. I still contend that the overall market move is entirely rational.
There is normally one geographic area of the world that is doing well and provides an opportunity for other economies. At the moment all the major economies of Europe have longterm difficulties, Japan has major problems and so has the USA. India has infrastructure problems and inflation, China has inflation problems and potential political problems which could start with no warning. The middle east has political problems and is perhapse less stable than normal.
The financial crisis could be seen as being in several phases. The first was the finance sector losing vast amounts of money, then the Governments effectively take on this financial loss, then the governments have to recover this loss by taxing private and corporate taxpayers (This is all made worse by the fact that most Government finances were unsustainable before financing the toxic debt). The original financial crisis has not disappeared, it has been passed on and renamed.
The banks still have very poor balance sheets and are having to use the 'profits' from their wise loans to pay the bad debts as they arrise. The Credit Crunch is likely to last many years - I suspect it will be serious for the next 3 years and then gradually ease.
The problems are massive and fundermental. The Governments have use all their weapons (They cannot reduce interest rates) and I think that the general concensus is that additional QE is unlikely to be effective - if you do not believe in the medicine it will not work.
There is one strange issue - Pension funds etc are receiving money and this needs to be invested. It could be that this source of finance will create demand for shares and start to get things moving again.
I have no confidence in my predictions as I predicted the financial crisis over 30 yrs ago! This means I have been wrong for 28 years!
http://www.economist.com/content/global_debt_clock
https://www.cia.gov/library/publications/the-world-factbook/rankorder/2187rank.html
These web sites (no restrictions on use as they are factual sites) shows the total world debt, per person and by nation. It is interesting to note that the so called "3rd world countries" have very little debt compared to the nations that class them as so.
Question remains - how is all this debt going to be repaid, and from what means and by who? The equity markets, for example, when we sell at a loss who makes the paper gain? If I have bought a share for $2 and now its worth $1, I sell, where has that $1 disappeared to? I assume there is a fixed amount of money in circulation and the decision to print more is decided upon individual gov't's. If i bought a share at $2 and sold for $3 then I have the profit and original investment in my pocket to spend as I please.
Other questions, How can a country with so much debt lend money to another nation (European bail outs) and also donate money to other nations for assistance i.e Kenya, Somalia, Ethiopia, Japan, Chile, Cuba (areas where natural disasters have happened, war torn regions etc etc).
I believe there is worst to come, I did not panic sell, I sold out purely on the basis that when you look at how the world trades (on negative balance sheets) the only safe haven is gold and silver. This is how the world traded centuries ago, 1 bag of gold = 10 bags of silver. This was how labour was paid for and how goods were traded.
When will the dollar collapse? (as it is pretty worthless at the moment). Is this why China & India are buying up Gold and rare earth minerals?
Is the value of the coins in your pocket really worth what they say? On every UK bank note it states that "I (the bank of England) promise to pay the bearer on demand the sum of"....But does it really have all that money it has promised to pay? They can't carry on printing as it devalues the currency. Interesting times ahead, please if any one has logical answers to some of my queries please email them to me at kishor@saelectricals.co.uk (as I am ever so confused by the day). The one thing they cannot take away is the smile on our faces.
In reply to kpatel92326, post #5
It's not as simple as taking a nominal figure on governemnt debt and asking when it is going to be repaid.
It's the percentage of this debt over GDP that matters.
Ultimately, as long as GDP keeps growing it's not really a major concern.
Governments have always had debt.
In reply to kpatel92326, post #5
The answer is by global growth - which is achieved by making the factors of production sweat harder and produce more. This not only includes labour (and not only the western unemployed and underemployed - but those in developing and third world nations), but also land and capital.
Of course one might argue that the present debt burden arises from having overleveraged the capital element in the pursuit of growth - and that needs to unwind ....but the slack can be taken up by labour and land (and various sub-categories that I'll leave economists to argue over) being used more efficiently.
What has to happen first though is a set of policies that encourage such growth - and at present far too much capital is being squirrelled away in fundamentally unproductive assets such as property and gold.....and this will ultimately have to be redeployed into investments that produce economic growth.
ee
I agree with the article . Buy shares now ! Steve
I don't believe that money produces economic growth as it doesn't represent anything concrete, as has been amply demonstrated recently.
You can't convert property and gold into growth since, they have little inherent value either.
Growth is bounded by physical limits, we are a lot closer to those, than we used to be.
The current economic model, without a cheap source of raw material and energy, is fundamentally flawed.
No amount of tinkering with interest rates, taxes or banking systems will make the slightest difference IMO.
The world economy may grow more, but the mineral and energy capital has to be spread thinner and thinner, individual standards of living in the west will likely fall, unless there is a radically different approach.
No sign of that.
I'd hazard a guess, that on a balance of probability - we face years of instability, and stock market stagnation with sucker rallies and sudden bear runs on the back of a major structural shift in the world's economy.
In reply to bugsmunny, post #9
The problem with that rationale bugs is it ignores technology enhancements which I'd argue are on the cusp of something quite revolutionary.
I don't deny there are some solutions for some problems for example fast breeder nuclear fission and nuclear fusion.
They aren't going to solve the other raw material problems or have much of an impact in the next 20 years.
What did you have in mind?
In reply to bugsmunny, post #11
I'm thinking more electronic doing away with paperwork & internet applications on the move.
"The world economy may grow more, but the mineral and energy capital has to be spread thinner and thinner, individual standards of living in the west will likely fall, unless there is a radically different approach."
The Simon-Ehrlich wager is interesting to read regarding this (http://en.wikipedia.org/wiki/Simon%E2%80%93Ehrlich_wager).
I think this quote from Julian Simon is pretty fair :
"More people, and increased income, cause resources to become more scarce in the short run. Heightened scarcity causes prices to rise. The higher prices present opportunity, and prompt inventors and entrepreneurs to search for solutions. Many fail in the search, at cost to themselves. But in a free society, solutions are eventually found. And in the long run the new developments leave us better off than if the problems had not arisen. That is, prices eventually become lower than before the increased scarcity occurred."
Obviously it's a theory and nobody can know for sure. With each year that passes more scientific research takes place and technology advances. That is what will solve finite resource constraints.
In reply to bugsmunny, post #11
These arguments are very relevant IMO, in relation to what are reasonable growth expectations. In the western world I would argue that the UK economy was running absolutely as fast as it could by 2007.....vast technological advances over the preceding 25 years, vast amounts of leverage being applied to capital, reasonably full employment etc etc. In other words, all the "good news" for growth (and more!!) was already priced into the market.....
....to some degree growth in the emerging economies has continued to pick up the growth baton since then - but I think there is a real chance that 2007 might represent a high water mark for equity markets for a couple of decades to come, because I don't see the sources for growth that are going to stimulate the economy even further. Indeed, demographics are another factor working against growth, as the baby-boomers retire, spend their savings and eventually die off.
So....unless there is going to be another ground-breaking technology that makes the productivity of labour much more efficient (and I really struggle to think how there could be one, after 15 years of solid development in the internet and mobile communications spheres), then I think that the west (especially the UK) is condemned to low-growth for a long period of time, irrespective of what we do about it......
...and that makes it essential to pay down debt - and continue to do so! We'd have been much better off if Labour has done that in Government, rather than stoking the boom with even more leverage.
So....if you want growth then look for economies where labour capacity remains substantial. India and China are obvious examples.....but, less obviously, perhaps Italy, France, Greece and Spain have more growth opportunities than one might think? After all, one might argue (I think) that their labour forces have been relatively underemployed as compared to in the UK......and pehaps the problems of the PIIGS are just the kick up the rear that their economies need?
Can anyone recommend some Italian-focussed investment trusts?
ee
I can't see technological advances slowing .... ever really. In fact I imagine they'll just get faster.
The chance of ground-breaking technology increasing productivity NOT happening at regular intervals for the rest of our lives seems remote.
Although there is still massive room left for improving, implementing and spreading the ground-breaking technology we already have.
In reply to morality, post #15
The key point is that not that technological change won't happen....it clearly will......but that I don't think that further changes will make much difference to overall productivity in the economy. Yes I guess it is possible that further changes can make "24/7 Man" slightly more productive than he already is( thanks to computers and mobile telecoms)....but it won't be very much - and it is quite likely to be more than offset by the growth in the numbers of (less well-educated or less technically-capable) under-employed people within the same economy.
In the biggest of big pictures, the markets are in thrall to debt and demographics....and technological changes will (in the future) really just be making minor cosmetic changes to a fairly gloomy big picture. As I said previously, 2007 was a debt-fuelled high-water mark for growth expectations in the West....
Maybe I'm just a dreamer. There are so many possibilities though! I just can't see things plodding along with slight superficial improvements.
I think the number of under-employed people due to lack of education will continue to drop... due to more of the population entering education and the resulting growth in innovation and productivity. I mean the world population there not just the UK. Imagine all the undiscovered geniuses out there, all the possibility that will be unleashed as the number in education grows and grows.
Which will lead to more innovation and more technological advances. We could have instant teleportation (or some virtual reality equivalent amounting to the same without physical movement of the body), massive increases in crop yields making food plenty for all, robotics taking over tasks normally performed by humans and doing it better and faster, graphene will give us roll up super computers.
Some of that may sound fanciful but we have already seen the small increments towards it.
Skype popped up and suddenly you can video chat for free all over the world allowing virtual classrooms and meeting and romances to pop up without any travel.
The roomba has started taking over a simple household chore.
There will be more and more. The advances in productivity are going to be huge. It would take a black swan cataclysmic event to prevent that.
Um... in my opinion. :)