4 minSome encouraging news
After the dramatic fall in stock prices last week, we are reducing our underweight position in equities. Over the past 2 months, the major stock markets have lost more than 30% on fears that the financial crisis would spiral out of control coupled with the prospect of an economic recession. I think that now is the time to turn somewhat more positive on equities again.
Why?
Firstly, valuations: equities have become quite cheap. Most markets are now trading at a Price-Earnings ratio of less than 10 (the long-term average is around 14). I have often argued in the past that current P/E ratios can be misleading in an economic recession as earnings usually suffer. In other words, what looks cheap today may look expensive in hindsight. Still, after the fall in equity prices over the past few weeks, the risk of lower earnings seems to be factored in at least to a certain degree. Given the uncertain outlook for earnings, it is however interesting to see where equities stand on other valuation criteria. The following graph, courtesy of Morgan Stanley, shows that last Friday, European equities were trading on average at 1.3 times book value, their cheapest level in more than 20 years.
The second reason why I am becoming less negative on equities is the encouraging steps taken by the authorities to fight the banking and economic crisis.
The following table shows 10 things I think the policy actions should achieve and the various measures taken to date:
| What I think should be done | Various responses to date |
| 1. Maintain the liquidity of the banking system; | - implicit and explicit deposit guarantees; - supply of open-ended liquidity to banks; |
| 2. Moderate the impact of deleveraging in the financial sector by helping banks raise new capital and by ... | - capital injections into banks considered 'too big to fail'. Furthermore, whereas in the cases of AIG, Fannie Mae or Freddie Mac, the US government only stepped in once existing shareholders had been completely wiped out, recapitalisation of the banks is now done on terms that offer an incentive to the private sector to participate; |
| 3. … taking troubled assets off financial institutions' balance sheets and by ... | - $700bn TARP (Troubled Asset Relief Program) plan passed by US Congress; |
| 4. … suspending mark-to-market accounting to avoid the forced sale of an asset by one bank wiping out capital at another bank. In the current market environment, banks are forced to mark down the value of assets they don't intend to sell simply because another bank is forced to sell these assets at distressed prices (as there are no buyers) to create emergency liquidity; | |
| 5. Get banks to lend to each other again; | - guarantee of new borrowing by banks eligible for recapitalization; - allowing the Federal Reserve Bank to pay commercial banks for their deposits. The Fed can thus act as a 'loan clearing house' by taking deposits from one bank and lending them to another, the idea being that if banks don't lend to each other directly, the lending will be done indirectly through the Fed; |
| 6. Help banks to recapitalize by creating positive yield curves through monetary easing (allowing banks to capture the spread between long- and short-term rates); | - simultaneous co-ordinated interest rate cuts by the most important central banks ; |
| 7. Encourage banks to provide credit to businesses again or compensate for the breakdown in bank lending by providing direct financing to the economy; | - creation of a commercial paper facility, allowing the Federal Reserve Bank to purchase commercial paper used by companies to fund day-to-day operations; |
| 8. Stabilize the US housing market by reducing the number of foreclosures through mandatory mortgage loan modifications; | |
| 9. Provide massive fiscal stimulus packages including infrastructure spending and tax cuts/rebates to lower income households to support economic growth; | |
| 10. Get developing countries - specifically Asia - to abandon their current growth model based on exports to the West, in favour of a growth model based on domestic demand |
As the table above shows, there has not been much progress on the last 3 points (which have more to do with the economic risks), but aggressive actions have been taken on most of the others.
It is also encouraging to note that whereas Europe's response was initially unilateral - every nation for itself - there now seems to be a European consensus on how to deal with the crisis.
In the coming days and weeks, we will be keeping an eye on the money and credit markets to see whether these measures lead to a narrowing of risk premiums and help to restore confidence. The litmus test will be if interbank lending picks up again . First indications are that things are moving in the right direction, albeit at a very slow pace.
There are obviously still many concerns. One risk in these times of unprecedented volatility is that buying too early can lead to huge short-term losses (between the time I started and finished this article, equity markets have risen by more than 10%). The second is that the global economy now seems to be heading towards a severe recession. The final and most serious risk is that all the steps taken by the authorities until now may not be sufficient to break the vicious cycle of economic weakness and financial crisis feeding on each other. This would then increase the risk of a systemic financial collapse and an economic depression. In such a scenario, there would still be a large downside risk for stock prices. The Morgan Stanley graph above shows that at the trough of the 1981 bear market, European equities traded at 0.8 times book value. To get to that level today, markets would have to fall by another 40%. Pessimists need only to look at Japan: nearly 20 years after the bursting of a real estate bubble, the Nikkei index is still 75% below its 1989 peak.
