Weekly outlook

Preparing for the upturn 

By Tom Stevenson, 31 December 2008

Markets will recover before the economy improves. Distracted by the prevailing mood of despair, investors risk missing the turn.   A year ago most investors and commentators were too optimistic about both the economy and markets. 2008 turned out to be worse for the economy and much worse for markets than anyone predicted. Unsurprisingly, the mood this New Year is significantly more downbeat. As far as the economy is concerned the gloom looks justified. But there is a meaningful risk that pessimistic investors will be caught on the hop by a market rebound.

"The opportunity lies in the judgement of what’s round the corner" Tom Stevenson

Markets can sometimes seem at odds with economic reality, running out of steam when the outlook is apparently set fair or rising sharply when the papers are full of gloom and doom. This might seem strange, but it is less so when you consider that the function of a stock market is to distil into a single price all the hopes and fears for the future of all the world’s millions of investors. In City jargon, it is a superb discounting mechanism.

This mismatch partly reflects the fact that much of the economic data that finds its way into the headlines is quite out of date. For example, the statisticians haven’t yet officially announced that the UK is in recession but no-one is likely to claim we are not already well into the downturn. It also reflects the fact that investors are principally interested in the value today of a future stream of income. What’s happening today is already baked into the price of an asset; the opportunity lies in the judgement of what’s round the corner.

This is why the gloomy economic outlook only matters for investors today if it turns out to be wrong. If things turn out as expected, the news is very likely already priced in. This is why what we are about to go through in the “real” world has been discounted by 2008’s painful market correction. And what a correction it has been. When the books are signed off this week, the fall in the UK stock market will only have been exceeded in one year (1974) out of the past one hundred. The fall in Japan’s is the worst ever.

When you look at what probably lies ahead, the market’s performance is understandable. Here, for example, are the forecasts of one gloomy but still mainstream economist (Howard Archer at IHS Global Insight):

• The UK economy will shrink by 2.7% in 2009, maybe more. By the end of next year GDP will be 3.7% below its peak earlier this year and recovery in 2010 is likely to be only gradual.
• Unemployment will rise from today’s 1.9m to 3.0m by 2010.
• Deflation is likely in the second half of the year.
• House prices will fall by a further 15% in 2009 and another 5% in early 2010 for a total peak to trough decline of 35%.
• Base rates will fall to 0.5%, maybe even zero, and stay low for the whole of 2009.
• Public finances will be even worse than current gloomy estimates because the government’s prediction that it will need to borrow £118bn next year is premised on only a modest economic contraction next year and then a decent recovery in 2010. This looks too optimistic.
• Sterling will remain weak, with further falls possible in the short-term.
 

Even if you argue that the UK stock market reflects the broader global economy rather than just Britain’s, the picture isn’t much brighter. Goldman Sachs expects the world economy to grow by an anaemic 0.6% in 2009, with sharply lower growth in the emerging world only just offsetting outright declines in all the advanced economies.

This is not a pretty picture at all, but arguably it is one that is already priced into very depressed markets. From a long-term perspective, share prices look cheaper than for very many years. According to Barclays Capital, shares across Europe are currently trading at just 1.3 times book value (excluding bombed-out financials) and 8.5 times earnings per share. They offer a dividend yield of 5.2%, much higher than the income from government bonds.

These are extreme valuations. Indeed, the UK market’s price-earnings ratio has only been at today’s level or lower 5% of the time since 1969. These rare periods included the bottom of the 1973-4 bear market, which preceded the dramatic recovery of 1975.

Current market valuations imply a decline in corporate profits over the next couple of years of around 40% and perhaps a little more. This is pretty much the average decline in earnings during those black periods when a banking and economic crisis have combined in that most unpleasant of pincer attacks. Stock market investors, in short, are assuming that things will be very bad indeed.

Arguably, fixed-interest investors in the corporate bond market are factoring in an even worse outcome than this. Over the past 90 years, according to Barclays Capital, there have only been five months in which the spread between the yield on US corporate bonds and Treasury bonds has been as wide as it is today.

Those months were all in 1931 and 1932 during the Great Depression, a point from which total returns from corporate bonds were very attractive – just over 20% a year between 1931 and 1936, for example.

Currently, an enormous amount of money is huddled for shelter in government bonds and money market funds. Indeed the amount of cash in money market funds is greater compared to that in corporate bonds and equities than at any time during the 30 years or so that these safe havens have been available to investors. Valuations and sheer weight of money, therefore, point to a recovery in riskier assets at some point in 2009.

Both of these factors are a necessary but not a sufficient condition for markets to recover next year. What is required in addition is a change in sentiment, which remains extremely depressed but which I predict will turn at some point in 2009. It is possible that a wave of company failures and redundancies in the early months of the year could keep sentiment subdued for some time but the mood will certainly change in time.

History shows that when markets do turn, often well before the green shoots of economic recovery are poking through the snow, prices can move very quickly indeed. The argument for beginning to drip money into the market, to prepare your portfolio for the upturn, looks stronger than ever. Remember, you have to be invested in a market to benefit from its recovery.