Deleveraging and forced selling make market unsafe
By Neil Hume
Published: October 24 2008 23:07 | Last updated: October 24 2008 23:07
City traders did not need to wait for the release of third quarter gross domestic product figures at 9.30am on Friday to get an idea of how quickly the domestic economy was shrinking. A quick look at the performance of the FTSE 250 told them all they needed to know.
Following Friday’s 5.5 per cent slide, the mid-cap index, which is considered a better reflection of the domestic economy than the FTSE 100, has now halved from its May 2007 record high.
Of course, it hardly needs saying that such a decline reflects fears that the UK is heading for an economic recession. But what sort of downturn will it be? A short, sharp recession or a long and painful downturn. And how far will corporate earnings fall?
They are good reasons for thinking the slowdown is going to be much more severe than anything in the past 40 years
Fortunately, there are several rough and ready ways to measure what is being reflected by current share prices. One method is to take the current forward price/earnings ratio of an index such as the FTSE 100 or FTSE 250 and compare it to its average forward p/e over history. The difference between the two, expressed as a percentage, is a calculation of the expected decline in earnings. James Montier, of Société Générale, undertook this exercise this week and found US market levels were implying a 20 per cent fall in earnings and Europe a 34 per cent drop. He says this decline is in line with the most recent of recessions.
Merrill Lynch has come to a similar conclusion. It has compared the trailing p/e for European equity markets to their 36-year average, adjusted to exclude the dotcom bubble years of 1999 and 2000. The difference between the two implies a 38 per cent drop in earnings, four percentage points more than in the previous four recessions.
However, they are good reasons for thinking the current slowdown is going to be much more severe than anything in the past 40 years. Indeed, history shows that slowdowns that follow periods of financial and banking distress are longer-lasting and deeper than normal.
The International Monetary Fund found that the average recession in developed countries since 1980 had lasted for just longer than three quarters. However, downturns preceded by financial stress have lasted for an average of almost seven quarters.
Robert Buckland, of Citigroup, thinks the current earnings downturn could be among the worst in the past four decades. In his view, global corporate profits will fall by as much as 40-50 per cent over the next two years.
A peak-to-trough fall of that size is by no means outlandish, given the recent credit binge that inflated the sales, earnings profits and earnings of companies.
Mr Buckland thinks this fall is fully discounted by the market. Over the long term, he says the global equity market p/e has been 17. Current valuations are closer to 10, which means investors are discounting a 40 per cent fall in earnings. Add on the 9 per cent fall already seen in this bear market and it means investors are pricing in a peak-to-trough fall of 50 per cent. So, whichever way one cuts it, a lot of bad news is now “in the price”. But what is not “in the price” is a depression such as that seen in the US in the 1930s or Japan in the 1990s. During the 1930s, US listed companies’ earnings plummeted by 75 per cent in just over three years, while in Japan they slumped 130 per cent into loss in a downturn that lasted a decade, according to Citigroup.
Of course, there are people, such as Nouriel Roubini, the New York University economics professor, who believe this could happen. He thinks it is possible that the S&P 500 index could fall from its current level of 875 points to 500-600 points.
Clearly, anybody selling at the moment has to believe that such an economic doomsday scenario will come to pass.
Unfortunately for those who do not, this is still not the time to be wading into the market. There is still too much forced selling and deleveraging by hedge funds, banks and other investors for the market to be considered anywhere near safe.
Until that process is complete – and nobody has any idea how long it will take – the only safe place to be is on the sidelines, preferably with a large pile of cash.
Copyright The Financial Times Limited 2008
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