Market Matters — October 2011

Confidence is the key. It seems to be building around the view that the euro-mess will be addressed; and so markets go on up in relief. From the 21% agreed in July (“all instruments will be priced to produce a 21 percent net present value loss)”, a 50% ‘haircut’ on Greek debt? Or possibly as much as 60%?

We’re pleased too, of course — but not convinced. You just keep on finding further confirmation of how ill-founded the world has become. For example, we learned recently that there is, apparently, $53 trillion in global dollar-denominated debt out there — but a total money supply of only $2.7 trillion in circulation. Would you buy a $20 dollar bill for $392?

Meanwhile, the French and the Germans still need to agree on how to recapitalise the[ir] banks. The French would like it done by an expanded European Financial Stability Facility (EFSF), which would be leveraged to do the job. They don’t want national governments backing their own banks because that would almost certainly lower France’s AAA rating. The Germans don’t want to expand the EFSF because that might threaten their AAA rating. Oh, and either way the EFSF itself also needs a triple A. But leverage will turn it, in effect, into a collateralised debt obligation (CDO). Will the rating agencies make the same mistake they made with thousands of mortgage-backed CDOs?

Another month and another acronym is back: the credit default swap (CDS). Franco-Belgian bank Dexia has gone down. Now Austria’s Erste Group has warned that it expects a net loss of nearly €1 billion this year — instead of a decent profit. Erste wrote down its CDSs, mostly exposed to Hungary and Romania, to market value at an overall loss on those alone of €450 million.

And yet when the European Banking Authority (EBA) ran its tests on European banks in July, Dexia didn’t just pass. It emerged as one of the safest banks in Europe (12/91). Perhaps that’s why the EBA is ‘re-tooling’ its next stress tests. This time a big write-down of all peripheral eurozone sovereign debt will be included. At least 66 of Europe’s biggest banks will fail and will need to raise around €220 billion of additional capital, analysts averred yesterday. The new/next tests are going to be, ah, stressful.

In short, this is all going to be volatile at best. All await 23 October, when a comprehensive new Franco-German plan is expected. No Maginot Line here. Anything short of a panacea will disappoint; and we know they don’t grow on trees. Then there’s the (ratifying?) G20 from 3 November in Cannes. Until and perhaps beyond then, up, down, flying around: those magnificent men in their flying machines.

We, meanwhile, remain canny with our investors’ money, favouring stocks with strong franchises, balance sheets and, often, decent and sustainable dividends. Happily, we are spoilt for choice. Why? We have been (re-)considering e.g. the lessons from The Triumph of the Optimists or Anatomy of the Bear. Forecasting the economic cycle may be fun; but it is unlikely to make you money. Good equity market returns are primarily the result of low starting valuations.

For those, secondly, and although of course it could fall further, the p/e ratio on the UK market is down to 10.3. Since 1965, that ratio has reached over 20 (in 1968/69 and 1999/00). Other than the low of 1974, when it fell to 3.2, the p/e has rarely traded below 8x and averaged over 14. So on most definitions the equity market is cheap and gilts are expensive. So it was probably time for a decent rally. And after a torrid time, investors could be forgiven for thinking that we all deserve a rally — or even two.

Source: Artemis as at 18 October 2011.

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