if everyone's expecting it, it must be so!
Party like it’s 1999? Emerging markets fuel equity rally
By John Authers
Financial Times
Published: October 2 2007 19:41 | Last updated: October 2 2007 19:41
On Monday morning, as fresh news of severe losses by the giant financial groups, UBS and Citigroup, revealed even more damage inflicted by this summer’s credit squeeze, the reaction of stock markets was clear. They rallied.
In Monday’s trading, the Dow Jones Industrial Average, still the most widely watched index of the US stock market, managed to top the all-time peak it reached on July 19. This was broadly representative of the most important developed market indices. The US S&P 500 index and Germany’s Dax index are within 1 and 2 per cent respectively of their mid-July highs.
Neither the S&P nor the Dow have closed as much as 10 per cent below their highs since July. Thus, technically, they never even suffered what analysts would call a “correction”. They were briefly more than 10 per cent below their highs at noon on August 17, but that afternoon regained all the ground they had lost as traders wagered, successfully, that the Federal Reserve would be forced to intervene the next day.
Meanwhile, emerging markets are on fire. The MSCI Emerging Markets Index is up more than 50 per cent over the past 12 months, and it has leapt up by more than 25 per cent since August 18, the day the Fed cut the rate at which it lends to banks. The biggest emerging markets have rallied even though they were already in nosebleed territory; in dollar terms, China’s Shanghai Composite is up 416 per cent since the beginning of last year, India’s Sensex is up 112 per cent, and Brazil’s Bovespa is up 133 per cent.
All of this has been achieved in the face of credit market conditions that have made finance much more expensive for companies. Cheap credit had been seen as a key factor in supporting equities, but now this crutch has been removed nobody seems concerned.
Emerging markets growth
The rally also comes in spite of continued exceptionally tight conditions in the money market, which suggest that the big banks at the heart of the world’s financial system are still anxious. Further, gold has just touched a 27-year high. Normally, when investors rush for the perceived safety of gold, it is because they are anxious about other securities and fear inflation.
US stocks
So why are equities rallying? The instinctive reaction of many in the fixed income markets is to put this down to stupidity. Equity traders simply do not know what they are doing, or at least do not understand the ramifications of the damage that has been done to the structured credit market.
Emerging markets
But there are more rational reasons for the equity rally. First, and most importantly, there is the Fed. Rate cuts tend to be good, at least initially, for stocks. If they are not, it is because they tend to coincide with the start of a recession. But the Fed’s action last week was plainly inspired less by worries about the economy than by a concern to avert a crisis.
MSCI World sector
Recent history, in turn, suggests that such “emergency” rate cuts by the Fed have the effect of inflating asset price bubbles. That is potentially great news for equity investors.
In October 1998, when the Fed under Alan Greenspan was forced to cut the Fed funds rate to bring back liquidity to the markets after the near-meltdown of the Long-Term Capital Management hedge fund, the result was also to stimulate markets that had not needed the help. Large technology stocks, and the growing wave of dotcoms, were the greatest beneficiaries. The Nasdaq Composite index gained 40 per cent in three months, and tripled in less than 18 months as it roared through 1999. This helps explain why many in the market now refer to stocks as “partying like it’s 1999”.
There is another example. In 1987, after Alan Greenspan’s Fed cut rates to avert a crisis in the wake of the Black Monday stock market crash, the response was again a bubble. That time, however, it was in Japanese stocks, which more than doubled in the two years after Black Monday, before beginning a long drawn-out collapse. “This is a classic event, which happens every decade. You have the Fed tightening, then there’s some kind of crisis, and then the Fed bails out, and when they do there’s another leg up for someone,” says Nick Raich, director of equity research at National City bank in Cleveland. “Each time it’s a different sector than it was in the previous decade.”
Traders know that both these incidents created bubbles that eventually burst. But they also know that in both 1998 and 1987, the euphoria created by the rate cuts lasted more than a year – plenty of time to make strong short-term profits.
Teun Draaisma, European equity strategist at Morgan Stanley, advocated selling in June, and then aggressively re-entering the market in August, for exactly these reasons. He says another “equity mania” is possible, with retail investors piling in and companies indulging in strategic mergers and deals. “If we are right, then equities could be set for a big, big rally,” he says. “Bulls will say that this uptrend is unbreakable after all the trouble that has been thrown at it. Emerging markets will be seen as the new growth engine that cannot be derailed.”
He also predicts that the episode will “end in tears” – but that still leaves time for investors to make fat profits in the interim.
As everyone is working on the same assumptions, gains could be limited this time. Tobias Levkovich, US equity strategist at Citigroup, who has been strongly optimistic on the market for most of this year, sounds a note of caution. “As most investors are now searching for performance data on past beneficiaries of Fed actions,” he says, “we suspect some ‘institutional herding’ may arbitrage away much of the opportunity fairly quickly.”
The Fed itself is also acutely conscious of what happened in 1999. If crisis in the money markets is indeed averted, the Bernanke Fed might well move much quicker than the Greenspan Fed did to raise rates and avert the risk of a big bubble.
A second, perhaps more solid reason for the equity boom comes from corporate earnings. Profits made by S&P 500 companies grew at a clip of 10 per cent or more for a record 14 consecutive quarters, until that streak ended at the beginning of this year. But results for the second quarter of this year – published to little attention as the credit crisis was intensifying – remained very robust, with an increase of 8.7 per cent. This was much ahead of expectations.
Now, expectations for the third quarter, which is just finishing, are very low indeed. According to Reuters, analysts expect a rise of only 3.3 per cent year on year for S&P 500 companies. Many are betting that it will be easy to beat those expectations and land a surprise. This is a well-established dynamic.
Bulls also point out that abnormally few companies have taken the opportunity to “guide” the market into cutting their forecasts, and that the big specialist Wall Street investment banks, whose third quarter ended in August, have already reported results that could have been far worse.
However, expectations for the fourth quarter and beyond suggest that analysts are banking on the credit squeeze to blow over completely, and for the US to avoid recession. According to Reuters, they are expecting growth of more than 11 per cent both for the fourth quarter and for the first quarter of next year. These numbers could turn out to be wildly optimistic in the event of a consumer-led slowdown in the US, which looks a real possibility. If growth is this strong, moreover, it would seem likely that the Fed would raise rates.
A third reason for optimism comes from the most popular valuation systems. They all suggest that stocks are cheap. The price/earnings ratio on the S&P 500 has dropped to its lowest level since 1996. The p/e on the UK’s FTSE 100 is similarly at its lowest level in more than a decade.
Another popular valuation system involves comparing earnings multiples on stocks with the yields on government bonds. When bond yields are low, the argument is that it becomes defensible to spend more on stocks, until equity yields have come down to a similar level. This is often called the “Fed Model” because at one point Mr Greenspan himself appeared from congressional testimony to be using it.
Bond yields have dropped sharply over the past few months as investors have pulled money out of the credit market and other relatively risky assets. Thus this model makes the stock market look like a very appealing “buy”. The 10-year US Treasury bond currently yields 4.64 per cent, while the S&P yields 5.56 per cent – one of the biggest gaps in decades. During the 1990s, bonds usually yielded more than stocks.
T here are strong theoretical arguments against both these valuation models. Profit margins tend to be cyclical, and appear to be peaking. Earnings multiples, in turn, tend to be lowest when profit margins are high. Thus, some analysts would say current low earnings multiples simply show that the market wisely does not expect corporate profits to continue at their current heady levels.
Rob Arnott, chairman of Research Affiliates in California, said: “What we have are earnings that are 50 or 60 per cent above their 10-year average. Historically, that happens about 5 per cent of the time. And historically, that’s a negative sign for earnings going forward.” The best performance on record after earnings had reached such a peak, he said, was for profits to grow by only 4 per cent the following year.
Another reason cited for optimism is that companies have been heavy buyers of their own stock (using cash, generally, rather than debt) to boost their earnings per share. This buying picked up during the crisis.
A further driver is the weak dollar. In many ways, the rally is a bet that the dollar, already at all-time lows following the rate cut, will fall further still. Among US stocks, the strongest performers of the past few months have been large multinational companies – laggards since the tech bubble burst in 2000. Their profits in dollar terms are directly improved by a weakening dollar. The Russell 2000 index, the most widely followed index of smaller US companies, is still down significantly since its peak this year, even with large caps at new peaks.
Meanwhile, for US investors, continued falls for the dollar make international investing look more profitable. For example, Germany’s Dax index is up 28.6 per cent in dollar terms this year, and only 19.2 per cent in euros.
With the Fed cutting, the dollar lost critical support. One of the simplest ways to bet on further falls for the dollars was to buy emerging market equities and switch out of smaller companies into multinationals.
This ties in with a final theme that has sustained equities: faith in the story of secular growth in the emerging markets remains intact. According to Emerging Portfolio Fund Research of Boston, last week alone $5.53bn (€3.9bn, £2.7bn) went into emerging markets funds, the strongest inflows in almost two years.
Mining and materials stocks, most exposed to demand from emerging markets, have performed best during the rally: consumer discretionary stocks, vulnerable to a consumer slump in the US, have done worst.
So the boom in equities is more than a rally based on the belief that cheaper money from the Fed will be enough to avert a systemic financial crisis. Equity investors are also betting that growth will come more and more from the emerging markets, which successfully “decouple” from the US, while the US economy will continue to weaken. And they are ready to pull their money out as soon as the bubble seems ready to burst.
Copyright The Financial Times Limited 2007
