Markets – The Fundamental View

The last 45 days have seen more than $4 trillion wiped off the value of global equities as many markets have fallen by double digits, seemingly in response to many worrying global events.  It would be a valid question to ask whether equity markets, which are widely believed to be a discounting mechanism, are anticipating a worsening outlook and as such, poised to drop considerably further.   Below, we address this question.

The worries appear to come from three sources: I would have the order as 3, 2 and 1.

1. Economic: World economic growth slowing dramatically.
2. Geopolitical: Take your pick from Isis to Ukraine to Hong Kong to Libya.
3. Epidemiological: Ebola.

On Ebola, we quote Randall Forsythe of Barron’s who wrote: “…the new media seem to have adopted the old newspaper motto of never letting the facts get in the way of a good story, at least in their reporting on Ebola, a disease far less transmissible than influenza”.  While we are aware of the possibility that a global pandemic can cause the global economy to contract by a massive 5% and reap havoc in the markets, we believe that the probability of this happening is extremely small, and that Ebola will be contained.

On geopolitical worries, they have all been known for a while, and the markets have probably already priced them in.  Rarely do such events create lasting damage to the markets.

We shall dedicate most of our time on the first issue – global growth concerns – which we view as the most serious.

Some argue that the huge recent fall in oil prices indicate weakening global demand and the fear of deflation.  If this is coupled with tepid economies in Europe, Japan and some major emerging markets (like Brazil and Russia), the worry is that it will lead to markets falling further in anticipation of weaker corporate profits.

We generally disagree with this thesis, and we do not believe that a more severe market selloff would be justified by fundamentals.  Let’s address the issues:

• Oil prices falling.  While global oil demand is expected to rise less than was expected at the beginning of the year, it is still expected to rise.  The main reason for falling prices is that a lot of extra supply has come online, especially from the US.  Lower energy costs will be a huge boost for consumers – especially in the developed world – as they shall have more disposable income.  With the exception of the global energy sector, most global companies are expected to benefit from both rising consumer spending, and also because the cost of raw materials has also dropped.
• Bond yields have fallen too much.  This might rightly be interpreted as a sign that growth prospects are weak.  But it also means that governments, corporations and consumers have access to cheap funding, which is a huge positive.  It also means that there is no pressure from rising wages and that inflation is in check.
• Europe is almost in recession.  Poor August data out of Germany spooked the markets, but on closer inspection some of it was due to calendar factors.  Germans continue to have a

healthy level of employment as well as solid real wage growth.  Also, despite continuing weakness in France and Italy, Europe should benefit from easy monetary policy from the ECB, the significantly lower Euro (boosting exports and reducing the probability of deflation), the moderation of fiscal austerity and falling energy prices.

• The Fed (US Central Bank) will end its latest QE program this month.  Without a doubt, the removal of this source of liquidity from the markets has had a negative impact, as has the shrinking ECB balance sheet.  Like a drug, markets have become addicted to this liquidity. Nevertheless, as the chart below shows, the combined balance sheet of the four big Central Banks is expected to increase, and this is positive for markets.

In the US, an improving labour market and lower energy prices should support the economy, and the strong USD will take pressure of the Fed to raise rates soon.  Excesses are a major cause of recessions, and there are few signs of this. With regards to the markets, there is nowhere near the level of ebullience that is seen near market tops, and corporations generally have healthy balance sheets, are by and large buying back their shares, increasing their dividends, growing their capital expenditures, looking for acquisitions, and generally being prudent with costs.  This is positive for earnings growth.

As for equity market expectations, the so called Equity Risk Premium (or ERP) – that measure the difference between expected returns from equities versus those from bonds – are flashing “buy equities” in both the US and Europe.  The charts below, from UBS show this:

The two charts imply that either bonds are expensive or equities are cheap.  Or, if the model (which calculates the ERP) itself is wrong, it implies that there would have to be major downgrades to earnings in the region of 29-45%.  This is huge and would be absolutely disruptive.  Earnings released so far for Q3, as well as companies’ forward guidance have been much more in line with expectations. So it is more likely that equity markets have over-reacted to the downside rather than anticipate such a huge fall in earnings.

So is there an “all-clear” to buy?  It would be premature of us to suggest that markets will start rising again tomorrow.  We are now in the highly volatile phase when they are attempting to bottom, and whether it happens today or in a month (and possibly 5-10% later), no one knows.  What we find comforting is that fundamentals point to the current phase as being no more than a market correction.  As Strategas Research Partners recently wrote:  “To the extent to which stock prices are generally driven by the intersection of expectations about future cash flows and interest rates, U.S. stocks look more attractive to us today than they did a week ago”.

On Market Timing

It would be remiss of us not to end this briefing without a word on how one should react, if at all, to the recent turmoil. {Parts of the below are from Driehaus Capital Management}.

It is widely established that human behaviour (be it greed, fear, herding or anchoring) leads investors to react to short-term market conditions in counterproductive ways. Specifically, investors tend to invest after a market (or a fund) is up and retreat after a market (or a fund) is down, thereby gaining exposure to the worst parts of the market over time. This is precisely why studies have shown that the average investor significantly underperforms the funds in which they invest.  Dalbar (www.dalbar.com) have published many reports on this, citing the following statistics. In the 20 years from 1993 to 2102:

• The average equity investor underperformed the equity markets by 4.32% per year
• The average bond investor underperformed the bond markets by 5.56% per year

Because nobody has figured out a way to reliably predict the performance of markets and funds, investors have been better served anticipating that corrections do and will happen and come to terms with the fact that they are normal, albeit uncomfortable, periods in which to stay invested. Those with long-term investment objectives have been better served to stay the course through market cycles with thoughtfully constructed portfolios that are diversified across asset classes and that are suitable, based on investors’ investment objectives and risk tolerance.

The Elgin Analyst Team

20^th October 2014

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