“If we mean to prosper long term, I am sure that we need to act to make debt less attractive to everybody: it really is a snare and a delusion.”
(Jeremy Grantham: Children at play, August 2011)

 “A novice monk approaches his teacher and asks, “Is this a bull market or a bear market? ” The teacher replies, “If it is a warm day, and I say that it is winter, will you still wear your heaviest coat?”
(John Hussman: Zen Lessons in Market Analysis, October 2009)

In the space of just two weeks, most markets have lost some 15%

Equity markets have seen something of a nosedive since the end of July. In the space of just two weeks, the markets shed 15%, and in some cases even more.

This fall can be explained by factors that are cyclical as well as structural.

• Key issues on the cyclical side are the deterioration of economic statistics , especially in the United States, and company results coming in below expectations.
• On the structural side, there is the public finances problem with the crisis in the eurozone and the distressing spectacle of the raising of the debt ceiling in the United States, followed by a cut in the country’s rating.

 But perhaps the tumble on the equity markets represents a good buying opportunity?

Source: S&P, Shiller, BLS, Global Financial Data, Morgan Stanley Research
Note : Shiller PE defined as inflation adjusted price to 10Y average EPS

From private to public sector debt

In recent weeks, investors have generally become aware of the fact that the economies of the majority of industrialised countries are fundamentally weak and that the rally of the last two years was largely artificial and is therefore still fragile. But it is no real surprise that these economies are weak: even 80 years ago, the economist Irving Fisher noted that the major economic problems stemmed primarily from excessive debt. Just as debt can (temporarily) stimulate growth, cutting debt hampers it since the money needed to reimburse debt is no longer available for consumption or investment. Furthermore, the actions of the fiscal and monetary authorities over the last three years have done nothing to improve the situation – on the contrary, they have aggravated it. What was initially a problem of excess debt in the private sector has become a problem of excessive debt in the public sector. The result is that the authorities no longer have the means at their disposal to stimulate economic activity. In fact, quite the opposite in most countries where budgetary austerity is the name of the game – austerity that will constitute an additional brake on growth. This makes a return to recession quite possible.

On the structural side, the problems associated with the deterioration of the public finances are still far from solved. Particularly in Europe, the situation is becoming increasingly worrying. The cut in the United States rating could end up causing more problems in the eurozone than in the United States. How can France’s AAA rating be justified when the United States has had that top status taken away? Yet if France were to lose this rating, the very mechanism on which the support for the peripheral countries is based (giving such countries access to capital at a reasonable financing cost via a vehicle like the EFSF which has an AAA rating) would be fundamentally called into question. Furthermore, the increase in the price of CDS (credit default swaps that act as an insurance policy against payment default) on Germany show that investors are even starting to wonder about countries hitherto considered as ‘beyond doubt’, as the measures taken to combat a problem of excess debt in the peripheral countries is in danger of generating a problem of excess debt in the ‘hard core’ of the eurozone.  

The economic environment does not look set to improve anytime soon. But is the bad news already discounted in share prices? After all, there are many commentators claiming that equities are particularly cheap at the moment.

Are equities cheap?

Where then are we in terms of valuation? To answer that, we tend to apply Shiller’s price/earnings ratio. As has been explained many times, this ratio has the advantage of using average earnings over the last 10 years as its denominator and therefore avoids being based on one exceptionally good year (producing a very attractive P/E) or one bad year (giving a very high P/E). The Shiller ratio is all the more justified in the current situation where corporate margins – at exceptionally high levels – are starting to come under pressure. On the basis of this ratio, the following conclusions can be drawn:

• The US market is currently trading at a Shiller P/E of around 20. The long-term average for this ratio is 16. Using that average of 16 would put the S&P 500 index at around 950, compared to its current level of 1,190. Note that in recessions, this ratio has fallen to 13.6 on average;

• The European market is trading at a Shiller PE of 11.5. This figure is slightly below its long-term average but is still considerably higher than the level reached in bear markets of the past. At the lowest point in the 2008/2009 bear market, this ratio fell to 9.7.

So generally, we could say that the US market is currently relatively expensive while the valuation of the European market seems a good deal more attractive. But this assessment should be put into perspective given the significant weight of financials in the European indices. Admittedly, financial stocks do appear to be very cheap at the moment but their shareholders run the risk of being heavily diluted by future recapitalisations.

The theme of valuations calls for two additional remarks. First, it is clear that all valuation models based on interest rates show that equities are exceptionally undervalued. However, the Japanese example shows that using this model in an environment of high debt, weak growth and a risk of deflation makes no sense. Second, while it is interesting to compare the valuation of equities to the long-term average, the fact is that equities very rarely actually trade at this average. The average is useful to see whether, compared to the past, equities are rather expensive or rather cheap but it is just as important to find out if we are in an environment suggesting an increase or a decrease in equity valuations. The current environment would suggest a rise in the equity risk premium and thus a contraction of the multiples.    

The equity markets’ recent correction does therefore not constitute a buying opportunity. While it is true that the dip in prices reflects a reassessment of the economic prospects by investors, it is nevertheless the case that the conditions for a sustainable recovery in stock prices are not in place: the economic and financial environment does not appear to be on the point of improving and equities are not cheap enough.

How to invest?

In such an environment, our investment strategy is based on the following three principles:

• in terms of currency, we prefer currencies of countries with solid fundamentals (budgetary surplus, current account surplus, and low public debt);

• in terms of bonds, in our funds we only hold debt from Northern European countries and certain emerging countries;

• in terms of equities, we confine ourselves to high-quality companies (low gearing, high profitability) and steer well clear of US and European financial stocks that most reflect the domestic problems of these regions. High dividends and emerging countries are key themes in our investment approach, and this includes US and European companies which derive a good proportion of their earnings from emerging markets. And we use derivatives (selling futures) to reduce the ‘market’ risk.