Market View - July 2014

“Euphoric capital markets are out of step with financial reality, warns BIS” was the headline in the Financial Times (FT) on the 30th June. The Bank for International Settlements (BIS) based in Basel has often been referred to as the central bank of the central banks, and in its annual report it suggests that a failure to raise interest rates early enough in many major economies at this stage of the financial cycle could result in capital markets getting seriously overheated and make raising rates later even more difficult for fear of triggering another major crash.

In summary, the BIS annual report which was published at the end of June says “The global economy has shown encouraging signs over the past year. But its malaise persists, as the legacy of the Great Financial Crisis and the forces that led up to it remain unresolved. To overcome that legacy, policy needs to go beyond its traditional focus on the business cycle. It also needs to address the longer-term build-up and run-off of macroeconomic risks that characterise the financial cycle and to shift away from debt as the main engine of growth. Restoring sustainable growth will require targeted policies in all major economies, whether or not they were hit by the crisis. Countries that were most affected need to complete the process of repairing balance sheets and implementing structural reforms.”

The FT suggests that failure by the Federal Reserve (Fed) and other central bank policymakers back in 2003 to heed similar warnings from the BIS that serious imbalances existed and that financial markets were precariously poised and needed corrective action, allowed markets to overheat and ignore what were in hindsight serious warning signs. Five years later as we all know global equity and bond markets were shaken to the core by the sub-prime debt debacle and the collapse of Lehman Brothers.

The BIS report continues “The current upturn in the global economy provides a precious window of opportunity that should not be wasted. In a number of economies that escaped the worst effects of the financial crisis, growth has been spurred by strong financial booms. Policy in those economies needs to put more emphasis on curbing the booms and building the strength to cope with a possible bust, and there, too, it cannot afford to put structural reforms on the back burner. Looking further ahead, dampening the extremes of the financial cycle calls for improvements in policy frameworks - fiscal, monetary and prudential - to ensure a more symmetrical response across booms and busts. Otherwise, the risk is that instability will entrench itself in the global economy and room for policy maneuver will run out.”

Food for thought as the S&P 500 in the US has recently been flirting with the giddy index level of 2000! At the end of June, the S&P 500 closed at 1960.23, up more than 4.5% for the quarter, almost 6% for 2014, and more than 190% since the current global bull market began on the 9th March 2009. Over the same five and a quarter years the FTSE 100 in the UK has risen more than 94%, with the index closing at 6743.94 at the end of June, up just over 2% for the quarter, but broadly flat since the beginning of 2014.

In other markets, the German Dax index closed June at 9833.07, up almost 3% for the quarter but flat for the year, while the CAC40 in France closed the month at 4,482.84, up a little over 2% for the quarter and more than 3% for 2014. Most Asian markets fared better in the second quarter than during the first, with the Nikkei 225 in Japan closing at 15162.10 up just over 2% for the quarter, but still down almost 7% for the year.

Meanwhile the Hang Seng in Hong Kong closed June at 23190.72, up just over 3.5% for the quarter, but broadly flat for the year, but on mainland China the Shanghai Composite closed at 2165.12 up more than 6% although it remains down more than 3% this year. The star major equity market performer of the quarter was once again the Indian BSE Sensex index which closed at 25413.78, up more than 13.5% for the second quarter and more than 19% for 2014.

US government bonds or Treasuries have also had a good 2014 thus far despite many market commentators expecting yields to rise inexorably on the back of the tapering of the QE asset purchase program by the Fed. Arguably the positive returns on Treasuries which for several years have benefited from the Fed’s zero interest rate policies (ZIRP) have been helped this year by interest rates in Europe having been driven lower on the back of actions by the European Central Bank’s President Mario Draghi introducing a number of measures including negative interest rates (NIRP) for some banking deposits.

Several market commentators believe the S&P 500 on Wall Street could easily go through 2200 before this bull market is over, and in addition to favorable tailwinds like ZIRP and NIRP, stock prices have benefited enormously from the extra money for investment created by Quantitative Easing (QE), as well as the increasing number of companies buying back their own shares. Reportedly last year alone, S&P 500 companies bought $475 billion of their own stock and in the first quarter of this year purchased another $160 billion.

As much as 80% of all the profits of the S&P 500 companies are being recycled into the hands of shareholders through buybacks and dividends, and this is the most powerful force pushing the market higher, and arguably explains why we have seen so few meaningful corrections in the past couple of years. In effect the major corporations are buying on all the market dips and have plenty of firepower left, as it is estimated that between the expected corporate buybacks and still to come QE, around half a trillion dollars could come into the market before the year end.

Many of the buybacks appear to be leveraged, where the companies are borrowing cheaply and using it to buy back their own stock. Some critics have argued CEOs are too focused on their stock options as opposed to taking decisions that will stand their companies in good stead for the longer term. Gary Dorsch of Global Money Trends in the US was quoted as saying “I believe we're sort of at that euphoric stage now where psychology kind of gets out of hand. The Fed realizes that they're blowing the bubble, but they have no inclination whatsoever to stop it through monetary policy and so it could very well be that we see this parabolic final euphoric liquidity surge.”

Here in the UK, valuations have not yet reached the same euphoric levels seen in the US stock-market (where the cyclically adjusted price earnings ratio for the S&P 500 is currently in excess of 25 compared to the century and a quarter long average of 16.5), although naturally we are always mindful that when Wall Street sneezes, other markets more often than not catch serious colds. What we have seen in the UK during 2014 is a broadly flat market as noted earlier, with the second tier companies typically listed in the FTSE 250 and FTSE Smaller Companies indices, which have outperformed the FTSE 100 blue chips for the most of the past five years, underperforming their blue chip peers this year due to various factors including the potential impact of rising interest rates harming the prospects of these companies which obtain a higher percentage of their profits from the domestic market than is often the case with the blue chips. We however remain confident that the threats are exaggerated, and that, longer term, these companies continue to offer attractive growth opportunities on a selective basis.

When it comes to building solid diversified optimal risk adjusted portfolios, we are always mindful of the wise words of the father of value investing Benjamin Graham who famously explained that in the short term the stock market is often a voting machine, potentially driven by momentum and sentiment, but over the longer term it always reverts to being a weighing machine, and accurately reflects a stock’s true worth.

We believe that, in the absence of a “black swan” event, or the central banks making a serious monetary policy error, global equity markets continue to offer the best risk adjusted investment opportunities for the foreseeable future. We would not however be surprised to see markets pause or even correct a little later this year before continuing to climb on the back of improving economic growth, and the likely continuation of shrinking stock supply, albeit against a background of mildly rising interest rates.