Market View - February 2013

The continuing exceptional performance of American companies resulted in three quarters of those that had reported in January exceeding analyst expectations, which helped the S&P 500 achieve its best start to a year since 1989!

Some analysts are excitedly predicting that the S&P 500 will soon surpass its nominal all time high of 1565.15 reached on the 9th October 2007 (although to exceed that figure in real inflation adjusted terms will require the index to climb through the 1700 mark). The story is much the same elsewhere, with the cyclical bull market that began for most global equity markets on 9th March 2009 seemingly gathering momentum, and disregarding the continuing debt and political worries that exist globally, and reaffirming the adage “A bull market climbs a wall of worry”.

Included in that wall of worry is our old friend the Euro crisis, and Avinash Persaud, an emeritus professor at Gresham College, London and former financier writing recently in The Economist newspaper warned “There is a hidden danger at the heart of the decision to establish the European Central Bank as the single supervisor of the euro zone’s largest banks by 2014”. Mr Persaud goes on to argue that the decision to put in place a single supervisor will have unintended consequences and instead of helping avoid the problems that occurred in the banking sectors of several euro zone countries, such as Spain, Ireland, and Belgium, will instead lead to more pronounced boom/bust cycles!

Some of Avinash’s thoughts are especially instructive “Whenever Europe stumbles, a stark choice emerges: “more Europe” or “abandoning Europe”. The shortcomings of the single currency are seen as proof that it must be augmented by a single everything. Yet the opposite makes more sense. A single interest rate brings benefits but one acknowledged cost is the difficulty of dealing with different credit conditions in different countries. Differentiated regulatory policy; tightening rules in booming regions and loosening them in others; addresses this failing and buttresses the single currency. A common regulatory policy, sitting alongside a common interest rate, would instead risk amplifying booms and busts, ultimately undermining the single currency.”

Avinash suggests Germany’s success is less to do with good banking supervision and much more to do with selling superior engineering to some of the giant emerging economies at the end of the old Silk Road and that the West could do worse than learn from eastern philosophy where “systems like nature and the human body are made stronger by dualities, forces that appear to be in opposition but are complementary. Systemic resilience requires functional diversity. European unity cannot be achieved by assuming away differences, but by recognising them. When it comes to regulating credit across Europe, high regulatory standards are needed, not common lending rules.”

Meanwhile over in America, the contents of an open letter from two prominent US Senators to The Justice Department suggests little has seemingly changed post-Lehman with regards to the privileges enjoyed by a few mega investment banks on Wall Street and the systemic risks their position and role in markets poses to the global economy! Senator Brown said “Wall Street megabanks aren’t just too big to fail; they are increasingly too big to jail. Already, the nation’s six largest megabanks enjoy what amounts to taxpayer-funded guarantee by virtue of their size, making it harder for regional and community banks to compete.

During January the S&P 500 climbed more than 5% while the FTSE 100 did even better rising almost 6.5%. Elsewhere, the FTSE Eurotop 100 climbed 2.7%, the Hang Seng in Hong Kong climbed more than 4.7%, the Shanghai Composite in China rose 5.1% and Nikkei 225 in Japan climbed more than 7.1%. The star performer of 2012 namely the MSCI India index had a more modest month climbing just 1.9%, while the JP Morgan Global Bond index (£ unhedged) fell 1.5%.

While many renowned market commentators express amazement at the global equity market’s continued rise on the back of unparalled global historic total debt, many others are even more concerned at what they see as the mother of all bubbles in western government debt markets and with cash and other low risk deposit options offering little or no yield, the relative value argument for equities becomes almost irresistible! So if supposedly equities remain the most reliable risk adjusted game in town, does it matter which equities?

Yes according to a recent Buttonwood article in The Economist newspaper titled “The Vale of Value”, which suggests that fashions are changing in the stock market and that “The general rise in stock markets this year may be disguising a fundamental shift within the market.” The article explains that on mainland Europe for example where for the past five years growth stocks have been the better place to be, this trend has begun to reverse and value stocks are starting to outperform!

The article sounds a word of caution however from none other than Warren Buffett who warns “Market commentators and investment managers who glibly refer to growth and value styles as contrasting approaches to investment are displaying their ignorance, not their sophistication”, before reminding us he prefers hybrid companies whom can both grow their future earnings, while also being priced cheaply relative to their “intrinsic value!” Additionally the Buttonwood article warns that value stocks are usually cheap for a reason and can become a “value trap” for the unwary.

The article goes on to explain how growth investing was all the rage as the dotcom bubble gathered momentum in the late nineties before investors came to their senses following the crash, and then backed value, which outperformed until the credit crunch, and subsequent Lehman debacle when growth stocks once more commanded a premium! The Economist article suggests one reason value is starting to come back into fashion is the more optimistic outlook for the global economy as the euro crisis and fears of a hard landing in China both recede, but just as importantly some of these stocks do really now seem bargains!

According to The Economist, an analyst at Morgan Stanley believes European value stocks are trading at a 47% discount to their growth counterparts! One cloud however in this apparent value silver lining is that most of these bargain stocks sit in just four sectors namely energy, financials, telecoms and utilities, which are all “potentially the object of government interference in the form of regulation, higher taxes, limits on their ability to raise prices, higher capital requirements (for the banks) or outright nationalisation (mining and oil companies in developing countries).

Added to this is of course the fear that the optimism currently felt about global markets might reverse, but as The Economist article concludes “once stock market trends start to develop, history suggests that they can last a long time. In America value stocks have underperformed growth stocks by 23% since the start of 1997 which leaves a lot of ground to catch up”

As ever while there are sound reasons for optimism, a cautious and considered approach to investment is always advisable in order to ensure the optimal risk adjusted results!