Wednesday 04th Nov, 2009

The Straits Times - 04 Nov 2009

MONEY MATTERS
Equities rebound likely to continue

Between April8 and Oct21, markets appreciated by 40% in US dollar terms without dividends re-invested

By JOSEPH CHONG

IN our contrarian call in BT on April 8 this year - 'No, the recovery isn't a mirage any more' - we predicted that global equity markets could rise another 35 per cent to year-end. Looks like we were too conservative. Between April 8 and Oct 21, global equity markets appreciated by 40 per cent in US dollar terms without dividends re-invested.
Despite the 60 per cent rally off the March lows, there are still many sceptics who question the validity of the rebound, given the very high unemployment in developed countries. We believe current stockmarket levels worldwide are not only sustainable but there is room for further appreciation over the next six months.
Here are some reasons why:

• Valuations: At the lows in March 2009, markets were, depending on the range of assumptions, cheap by 50 to 100 per cent. Some markets had fallen to below book equity value. Investing was more a question of courage, not intellect.
Since the rally that started in March, under-valuation has shrunk. Based on measures such as the price-to-earnings and price-to-book ratios, as well as compared with bond yields, global equity markets are still about 15-20 per cent under-valued. Interestingly, a further 15 per cent move up will take us up against a significant technical resistance level.

• Corporate profits: The recovery in corporate profits in 2010 will be robust worldwide. Already we see third-quarter 2009 earnings coming in strong on the back of cost cutting. Companies have been helped by the tailwind of producer prices falling very much faster than consumer prices.

Also, many large bellwether firms have been guiding that they expect revenue growth going forward. Lower breakeven points combined with even very moderate revenue growth will generate a widening of profit margins.
Indeed, the most recent US GDP data shows that corporate profit margins recovered from 5.8 per cent in Q4 2008 to 7.4 per cent in Q2 2009, despite shrinkage in real and nominal GDP in the first six months of the year.

• Un-invested cash: These levels are still high and this is the most likely reason why equity valuations may overshoot on the upside. Cash is like charcoal at a barbecue party - it is one indicator of how long the party can last. The rise in equity markets has not been accompanied by a significant fall in cash levels. This can be seen from the levels of institutional money market funds, which spiked as the crisis unfolded at the beginning of 2007. Terrified institutional money only started to return to equity markets in July/August 2009.

For example, the sidelined cash to market capitalisation of the US markets have yet some way to go before normalisation. The ratio of cash on the sidelines to market capitalisation continues to remain at elevated levels, despite the market rally. We have defined cash on the sidelines as deposits at banks and thrifts plus retail and institutional money market funds. Cash-on-sideline data was sourced from the US Federal Reserve. During normal market conditions, this ratio ranges between 0.55 and 0.6. We are currently at 0.91.

·  The flow-of-funds argument does not apply here. A rise in equity market capitalisation of US$1 trillion does not necessarily lead to a cash draw down by the same amount. The market rises in value because, on an aggregate basis, investors have chosen to increase their allocation to equities. At the margin, even if the re-allocation shift may be a small one, this causes buyers to outnumber sellers persistently, thus causing prices to rally. The same logic applies with values in the property market and other asset markets.

Notwithstanding the reasons to remain bullish, we see two main risks to the recovery: errors by policy-makers and the absence of a turnaround in unemployment.

·  The sustainability of the recovery is contingent on fiscal stimulus allowing the economy to gain traction and grow while monetary policy remains easy. The risk of this is that consumer price inflation could be a problem down the road in 2011 - an evil that is manageable when the time comes. There is a risk that policy-makers may move too early. So far, this has not been the case.

The Bank of England has opted to continue with its quantitative easing despite the end of the British recession, while Australia's central bank has correctly raised its benchmark interest rate by a total of 50 basis points because job growth has resumed Down Under.

Not surprisingly, investors have bid the Aussie higher as they search for a store of value. This is the same reason why gold and other hard assets have rallied since the beginning of the year - not inflation but the scramble for a store of value. This is also the reason why we have started to trim our profitable exposure to gold miners - the gold price faces headwinds from rate hikes.

·  Despite the turnaround in production, orders and corporate profits, job losses continue in most of the developed economies, albeit at a much slower pace than six months ago. Net job creation is not happening yet because of surplus capacity.

Although end-demand has picked up, it has not recovered enough to absorb surplus capacity in plant, equipment and labour. Without net job creation, the recovery will eventually stall and the economy will move into contraction mode.

Equity investors are, therefore, now focusing on employment-related data - seeking affirmation that job creation is in the pipeline. So far, the data has continued to point in this direction. But we are not there yet.

The writer is CEO of financial adviser New Independent. He welcomes feedback at : josephchong@ni.com.sg

This article is for information only. Readers should seek independent advice before making any investment decisions