"If something cannot go on forever, it will stop" (Stein's Law) 

 

There is no doubt that the recovery on the equity markets since March has been impressive. Since their lows of 9 March, the European and US markets have bounced back by around 45 %, while for some of the emerging markets, the figure was closer to 100 %. And although the sharp recovery that started in March seemed to be gradually losing steam by May, the markets began soaring again in mid-July. I think it is therefore useful to look back on the factors that prompted me to recommend a defensive strategy at the start of July and see whether they are still relevant.

The following explanation is usually given for the recovery on the markets since March: at the start of March, the stock markets were discounting a nightmare scenario and equities were extremely undervalued. Large-scale interventions by the authorities then stabilised the banking sector. The stimulus programmes implemented by the various countries thereafter laid the foundations for economic recovery. Recent data shows that the recession is over. In the second half of the year, economic growth is expected to be boosted as businesses start rebuilding their inventories. The recovery in corporate earnings, the low level of interest rates and the amount of excess liquidity continue to support stock markets, especially as equities are not overvalued on the whole.  

Although this reasoning seems logical, it has a number of flaws.

First, while it is true that stock markets were oversold in March, they were not extremely undervalued. Multiples at that time compared favourably to the average of the past 25 years, but were still much higher than those seen at the end of the great bear markets of the past (see my article of 7 April). Those markets ended on average with multiples some 30% lower than those seen in March. In this light, the assertion that the markets were discounting an economic depression 5 months ago seems exaggerated to say the least.

Second, despite the current calm, the problems in the banking sector are far from being resolved. The Bank for International Settlements (BIS) said recently that only limited progress has been made in clearing up the global financial system. The deterioration in the situation in the commercial property market is likely to create new problems for banks. In May, the commercial mortgage delinquency rate in the United States was 2.7%, its highest in 10 years.  According to Federal Reserve data, at the end of 2008, around 12% of financial institutions had commercial real restate loans that exceeded five times their basic capital, contrasting with 2% in 1993.

Finally, even though recent economic indicators seem to show that economic activity is no longer deteriorating, most of these indicators fall into the category ‘not as bad as expected’ rather than ‘good’. The stabilisation in economic activity has only come about thanks to massive government expenditure whose future cost to society is currently impossible to evaluate. In the United States, the contribution of the stimulus programmes to growth will soon pass its peak and, short of new programmes being launched despite a record budget deficit, will gradually run out of steam. The common thread running through all the stimulus programmes is the desire to perpetuate the growth model of the past 25 years by artificially boosting private consumption rather than the desire to put the economy back on track for sustainable long-term recovery. The renewal of the Cars Allowance Rebate System (CARS), also known as ‘Cash for Clunkers’, at the start of August, a subsidy designed to boost the automobile market, is a good example of this. The programme has managed to stem, or at least slow, plummeting car sales in the United States. Car sales accordingly rose to their highest level in 10 months in July. The recovery in the automobile sector is currently having a positive impact on a number of economic indicators.  Most economists are forecasting growth of between 3 and 4% for the current quarter with some estimates running as high as 5%. The fact remains that the programme is only bringing forward future demand and once it comes to an end, the positive impact on the economy will quickly fade away. According to a recent survey by the CNBC channel, 90 % of economists in the United States believe the recession is over. There is however currently no certainty that without the help of massive government spending, the US economy is able to stand on its own two feet.

That economic activity being close to bottoming out, or even at the dawn of a period of robust growth in the second half of this year is one thing: more important, however, at least for investors with longer investment horizons, is the fact that the conditions for a sustainable recovery are not in place. In my article of 8 May, I explained why I believe economic growth is likely to disappoint in the coming years. The main reason is that the US consumer and the financial sector, whose continuous increase in leverage had inflated growth in the past two decades, have embarked on a process of deleveraging that is expected to last for a number of years.  In April and May, American households thus saved the tax credits offered by the government rather than spending them (which is why the US savings rate surged from 0.4 % in August 2008 to 6.9 % in May).  The deterioration in the labour market will not encourage the US consumer (70 % of the American economy and 20 % of the world economy) to quickly abandon his/her new thrift. As Bob Herbert wrote recently in the New York Times: "How do you put together a consumer economy that works when the consumers are out of work?" Meanwhile, in the banking sector, the latest figures show a record decline in lending to households and businesses.   

In my article of 8 May, I discussed the risks of a defensive investment strategy saying:

- that my pessimism about the ability of the US economy in particular and the world economy in general to stage a strong sustainable recovery might be overdone;

- that economic activity might recover temporarily before slumping again;

- that the stock markets would continue to benefit from significant liquidity inflows.

Although these risks are still present, they are much less significant today for the simple reason that the markets have gained around 10% since May. It is always helpful to bear in mind that as equity markets rise, good news is more and more discounted. At the start of March, most investors were very pessimistic, and it was enough for news to be a little less bad than expected to spark a recovery on the stock markets. Today, the markets are 50 % higher and at current levels, a significant recovery is starting to be priced in. It is important to note that another argument usually put forward to justify the recent rise on the markets, i.e. that most companies' second-quarter results were better than expected, needs to be put into perspective.  First, analysts had lowered their estimations over the past few months to such a low level that expectations were not very high. Second, as in the first quarter, company sales were overall very disappointing.  Profits were better than expected because of very good cost control. A strategy of cost control is only efficient to a certain point however, especially since the costs of one company are the revenues of another, or, in the case of labour costs, the revenues of households.

In sum, a defensive strategy seems more necessary than ever. A rise of around 50% in share prices in 5 months is rare. There are more or less four precedents in the history of the stock markets. It is interesting to note that two of these happened during the great bear market of the 1930s. The third occurred in 1974-75. In each case, if an investor had bought after such a rebound, he would have experienced significant losses in the years after. The exception is the period between August 1982 and January 1983, which marked the start of the great bull market which lasted until 2000. The current situation is not comparable to that period. In 1982, equities were extremely undervalued. After two oil crises, inflation, and, by extension, interest rates were high. The decline in inflation and interest rates in the following years contributed to the world economy entering a new era of prosperity and gave rise to a revaluation of equities. Today, equities are much more expensive and the current economic environment is marked by strong deflationary trends and low interest rates. Such an environment is not conducive to higher valuation multiples.