@GW – You seem quite pessimistic about the economic situation. But a number of indicators are now pointing to recovery.

It is very important not to confuse factors that are temporary with those that are sustainable. In the short term, the economy might well continue to benefit from temporary factors such as the economic stimulus plans put in place by governments and corporate inventory restocking. But governments cannot eternally increase their spending and corporate restocking will quickly stop if there is no final demand. To get a lasting recovery, we need sustainable growth impulses. The signs are not particularly encouraging in this respect. The US consumer and the banking sector, whose ever-increasing recourse to leverage had inflated economic growth in recent years, have now entered a deleveraging process that will last for years and is likely to weigh on economic recovery.

The growth model of recent years seems to me to have run its course. Under this model, the global economy was led by the United States, the US economy by the consumer, and the US consumer by a decline in savings and an increase in debt. To realign the global economy, the United States will have to save more while countries with a high savings rate and a trade surplus will have to consume more. Simplifying this somewhat, the Asian consumer will have to replace the US consumer as the growth engine for the world economy. This won’t happen overnight despite some encouraging developments. To accelerate the transition of Asian countries from growth based on exports to growth based on internal demand, they will have to accept a strong appreciation of their currencies which are significantly under-valued at present. As for the industrialised countries, it is disappointing to see that their stimulus programmes are often characterised by a determination to perpetuate the growth model of recent years that promotes consumption – the car scrappage scheme being a good example.

@GW – You often say that the valuation of the equity markets is not attractive. But many analysts are saying that stocks are cheap.

If we start from the hypothesis that the global economy is at the dawn of a strong and sustainable recovery, it’s true that shares are not too expensive (though I think "cheap" is a bit exaggerated). In the United States, the increasing consensus among analysts is that companies in the S&P 500 will gain an average of $75 per share in 2010. The S&P 500 index is currently trading at around 1066, which would give a price/earnings ratio (PER) of around 14, slightly below the historic average.

The answer to the question of deciding whether shares are currently at attractive valuations or not therefore depends on one’s view about which way the economic situation will go. If, as I think, the recovery is not going to live up to expectations, profit forecasts for 2010 will be disappointed and the valuation of the markets is not attractive. If on the other hand, the recovery is strong (and sustainable!), company results could be pleasantly surprising, especially as many companies have used the opportunity of the crisis to dramatically reduce their cost structure.

In saying the above, I have used the price/earnings ratio (PER) as the basis for judging the valuation of shares. The problem with this ratio is knowing what denominator to use: earnings (known but depressed because of the recession) of the last 12 months? Estimates for 2010? To get round this problem, analysts often use other ratios such as the Shiller PER, where the denominator is the average earnings for the last 10 years (the idea being that taking an average of 10 years will have a smoothing-out effect), the price/book ratio or even the dividend yield. Based on any of these ratios, shares are currently not cheap.

@GW – Isn’t it possible that the high levels of cash waiting on the sideline will lead to a continuing rise in share prices despite the absence of any improvement in the fundamentals?

I think we should be extremely cautious with the argument currently being advanced of "abundant liquidity". This argument is generally used when people can’t think how else to explain a rise in share prices. In the past, we have often seen that liquidity that was thought to be abundant could disappear from one day to the next. In fact, I don’t think that liquidity today is that much higher than at the beginning of March when stock prices were 35% lower, even though it is true that the liquidity that governments have injected into the system is tending to find its way into financial assets since the real economy doesn’t need it.

Whatever the case, a strategy that consists of recommending equities not because of their fundamentals or their valuations but because of arbitrary factors such as liquidity is incompatible with our investment philosophy. We then enter the realms of speculation.

@GW – You recommend a defensive strategy. Does that mean you think an equity market correction is imminent?

I try to avoid making forecasts about what will happen to share prices in the short term since this is often totally decoupled from the fundamentals. But having said that, it is obviously possible that share prices could be higher at the end of 2009 than they are today, with the real test for the markets coming in 2010. In the short term, the stock markets might continue to benefit from a very favourable environment: investors have chosen to ignore bad news (the reaction of the markets to bad US unemployment figures in September being a case in point), company profit forecasts for the third and fourth quarters have been revised sharply downwards (so a great many companies will now be able to beat them), and the authorities have let it be known that they are not going to increase interest rates any time soon. But this type of short-term reasoning is just that (i.e. short-termism), and should not serve as the basis for a serious investment strategy.

@GW – So should we be abandoning equities completely?

No. Instead, what I think we should be doing is abandoning sweeping generalisations like “What will the markets do?” and look closely within the markets to see if there are regions/sectors/companies that combine solid fundamentals with a reasonable valuation. Without talking about individual stocks, I would focus on three major themes:

• the industrialisation of Asia (linked with the commodities theme);
• quality companies (defined as companies with sustainable high profitability, low leverage etc.), which have generally underperformed in the market recovery since March and whose valuation is now attractive;
• dividends.