Could this be the most delirious call on stock prices in the modern era? And when we say “delirious,” we mean in a thoroughly joyous sense. There is no suggestion that the pundit in question might have been on the mescal.
Morgan Stanley’s European strategist Teun Draaisma (who said ‘Sell, Sell, Sell’ back in June) this week issued his latest Euroletter note. Entitled Think Big, it sets out the intellectual underpinning and blue sky optimism behind the bank’s call, on August 13, for investors to go overweight equities.
The contents were previewed earlier, during FT Alphaville’s daily Market Live discussion. But such is the bullish optimism of Draaisma and his team, such is their readiness to make a career-making or breaking prediction, that we’ve decided to reproduce the Draaisma Call in full.
We received a healthy amount of pushback on our call from mid-August to start buying equities again. Pushback is good. We know that we may well be on the right track with a call, when we get a lot of investor pushback. It means we are not consensual. Six to twelve months later, with the benefit of hindsight, we know we will look very silly or very right. We see 12% upside to our 12-month target of 1750 on MSCI Europe,and we recommend investors start building positions now, as it is possible that there will not be a better entry point.
Our bull case, overshoot-type scenario, implies 21% upside from here. Since the market troughed on August 16, MSCI Europe is now up 7.7%. Our preferred sectors are Tech & Telcos, Healthcare, Financials. Our least preferred are Consumer-related areas.
Building the base for a mania? There are many risks at the moment. But imagine that we get through this financial turmoil,and an uptrend in equities resumes, as we expect. In this piece we describe why we think that will be the case. If we are right, then equities could be set for a big, big rally. Bulls will say that this uptrend is unbreakable, after all the trouble that has been thrown at it. “The cycle is dead”, and “this time it’s different” will be heard all over the place. Emerging markets will be seen as the new growth engine that cannot be derailed.
This final leg of the bull market will be characterized by all the things we have not seen yet this decade, including big retail buying of equities, big strategic M&A, an increase in corporate confidence leading to a capex boom and multiple expansion in equity markets. There would also be a real mania in certain concept stocks,probably mostly in those related to commodities, infrastructure and emerging markets. Remember that it was only after the 1998 correction that the likes of Nokia and Ericsson went to 70 times PE multiples.
Of course, it won’t be different this time,and as always it will all end in tears, eventually, probably when higher inflation and rates lead to the next recession. But if we get through the current financial crisis, it is highly likely that the next phase in equities is a mania of epic proportions.
It is of course possible that we have not seen the trough in this correction yet. There are many uncertainties around, and markets do not like uncertainties. The money and credit market problems are very serious. More financial losses will be uncovered. Large parts of the credit and money markets are dysfunctional. Suddenly investors have to familiarize themselves with concepts such as SIVs and ABCPs. This decade’s bull market has been built, to a large extent, on an appetite for debt and structured products, and that appetite has certainly peaked for years to come. The Anglo-Saxon consumer is likely to be weak in the coming 1-2 years. With so much uncertainty around, it is even more difficult than usual to tell what the future will hold. In 1987 and 1998, two previous periods of severe financial crisis which turned out to be bull market corrections, not the start of recessions, there were double-bottoms in equity markets, and several Fed rate cuts were needed to stabilize markets. In such a bear case scenario, MSCI Europe could fall by some 17% from here, in order to reach crisis valuation levels of -2 standard deviation cheap on our CVI. See Finding the Trough, August 20, for more detail behind our scenario analysis. This suggests that the price of a wait-and-see-approach to today’s market may not be that high, and wait-and-see is indeed what most investors are doing.
Wait-and-see may indeed be sensible and prudent, but everyone is doing it. The virtually unanimous mantra among investors is: “I am not going to take big risks now. I would like to wait a few weeks to see investment banks report (week of September 17), the Fed act (next FOMC on September 18),and to see the next batch of economic data before committing more money one way or the other (eg, US CPI on September 19).” Even the bulls, those that are convinced that the market will be higher 12 months from now because they think the economic growth outlook outside the US is good and the US slowdown will not be big enough to derail this outlook, even they see no hurry to buy. This wait-and-see approach is quite understandable. Focusing on capital preservation in periods ofuncertainty is prudent and sensible. Especially if you are lucky enough to be sitting on good gains for the year, sitting tight and waiting is undoubtedly a prudent and wise thing to do. But the problem with the wait-and-see approach is that everyone is doing it, and this consensual attitude may well prove to be a mistake.
As a result, there is a good chance that equity markets have already troughed and will not offer a better buying
opportunity. In bull market corrections you should buy early and sell late. The very fact that everyone is waiting and seeing,increases the chance that we have already seen the equity market trough on August 16, in our view. On the one hand, the biggest pain trade is undoubtedly for markets to keep tanking and to go down by 50% from here. However, a pain trade that would catch market participants off-guard is that there will not be a better buying opportunity, and that the market edges higher day by day, and enters its mania phase next. Two months from now, suddenly, investors would need to scramble back in, having missed the first 10%. Exhibit 13 shows the history of bull market corrections. It is interesting to note that the biggest intra-correction rally has been 6.2% in the 1987 correction. Therefore, the fact that between August 16 and September 4 the market rallied by 7.7% also increases the likelihood that we will not go to new lows in this correction, we think.
The bearish extreme: equities will be down more than 50% in the next recession! Timing of that next recession is everything, but it will be horrible. We estimate that if the recession starts today, equities could go down as much as 70%. This is because in such an environment ROE will go from its current high of 17% to trough level of 8%. This implies that earnings will approximately halve if book value stays constant. Furthermore, at the end of severe bear markets, the PE multiple often has reached around 10, compared to its current level of 14. This combination implies up to 70% downside. We don’t think this is a very likely outcome in the next 1 or 2 years, as we discuss further on. We do think, however, that of three scenarios: mania, recession, or muddle-through, the muddle-through scenario is the least likely.
Let’s analyse how we get to that conclusion, using the three pillars in our approach: valuations, sentiment, fundamentals.
Valuations are attractive
Our market timing indicators, which gave us a full house sell signal in June (see A Full House Sell Signal, June 4, 2007), are now at much more attractive levels. We don’t have a strong buy signal yet, at levels of -2 on the CVI or the capitulation indicator for instance, but both these indicators were very close to -1 on August 16. This means that the correction we have experienced was equal to an average bull market correction, and the entry point is attractive. With a score below 0 on our Composite Market Timing Indicator, like we had in the second half of August, the average next 6 month performance in equities has been 7.7%, with the market having been up in 81% of observations.
If you believe the earnings, PE ratios are very low. We are the first to admit that reversion-to-the-mean of margins and earnings levels is inevitable, as the law of economics dictates, but reversion-to-the-mean will only happen in the next recession. As long as top-line growth comes through, cost pressure can be absorbed through growth, and margins can stay close to their current peak levels. This indeed has been the pattern observed in the last few years of previous bull markets. If earnings are roughly right, PE ratios are very attractive.
The share of the market that qualifies as a Benjamin Graham Value stock is at an all-time high, as we show in Exhibit 20. Again, this conclusion does depend on whether earnings are sustainable or whether they will collapse. But there is a marked contrast between how many Benjamin Graham value stocks there were in 1998-2000, and now. The long-term average share of the market that qualifies is 5.0%, versus 16.2% today, which is the highest share of the market to qualify as a Benjamin Graham Value stock since 1992, narrowly beating the previous all-time high of early 2003.
Sentiment is negative
The weekly put-call ratios reached an all-time high in the third week of August, based on weekly data since 1995. The skew — which measures how popular put options are in comparison to call options — reached an all-time high, too, based on data since 2001. These are bullish contrarian signs, with very favourable odds that markets are up in the subsequent 6 months.
Our favourite sentiment indicator for European equities from the futures market is the CFTC data on the NASDAQ. Currently that displays a 1 standard deviation net short. From levels of 1 standard deviation shorts or more, MSCI Europe has gone up an average 9.9% in the following 6 months, up 91% of the time. We like those odds.
Our capitulation indicator, which is based on price action and the breadth of the correction, suggested that there had been capitulation in the middle of August. The reading reached on August 16 (the trough, so far, in this correction) was -0.84, compared with an average trough reading of -1 in bull market corrections in the last 25 years.
Weekly mutual fund flows into emerging market equities showed an outflow in the week following August 16, consistent with market troughs. When the retail investor starts selling it is often a sign of the trough having been reached.
Finally, as mentioned earlier, most people are now staying on the sidelines, waiting for more clear signs as to whether they should be bullish or bearish. Investors who can use leverage to increase their gross exposure are using a much lower amount than usual, and our strong sense is that most deleveraging among stat arb and quant funds has been done. There are plenty of sources of money to be invested in equities, potentially, from asset allocaters, retail investors, hedge funds by increasing their gross exposure, corporates by using their strong balance sheets to embark on strategic M&A or buybacks, sovereign wealth funds and uninvested private equity.Fundamentals are uncertain and risky, but because inflation is not yet a real problem, rates are flexible and can stabilize the growth outlook, eventually. And remember, if things get less bad, that would be good enough for markets to go higher.
Global growth prospects seem good. Dr KOSPI, Dr Copper and Dr Baltic Dry, all those market barometers of the growth outlook who deserve the title of Dr because of their PhD in economics, are voting with their feet and telling us the global growth outlook is intact and good.
US slowdown. This rosy picture for global growth is in contrast with some of the US-based indicators, which indicate slowing growth. Our US economist Richard Berner expected 1.9% GDP growth in 2007, down from 2.9% in 2006, and 2.6% in 2008 the last time he released his forecasts, in early August.
Soft decoupling is the norm. A US slowdown, provided it is not a severe slowdown, doesn’t usually affect the rest of the world too much. A recent study by the IMF shows this point very nicely. Whenever the US GDP growth deceleration from one calendar year to the next is less than 2 percentage points, the rest of the world has been unaffected historically. Whenever the slowdown has exceeded 2 percentage points, the deceleration in the rest of the world has been very pronounced.
Currently our US economists expect a deceleration of 1%-point in 2007, far below the threshold. In addition, many emerging market specialists, including Stephen Jen and Jonathan Garner, are effectively arguing that the US matters less now than it has in the past, which implies the 2%-point deceleration threshold may even be higher now.
Europe should whether this storm well. In two recent pieces by our European economists they explain that house prices are at similarly stretched levels in Europe as in the US, but the European consumer is in much less precarious situation because its savings rate is high and the subprime market is absent outside the UK (See How Susceptible Is European Housing to US Problems? by David Miles, August 30, 2007). Furthermore, in examining the transmission channels through trade links, credit tightening and house prices, they conclude that the euro area should prove relatively resilient. Within countries, Spain appears to be the most exposed to tighter credit conditions, and Germany is most sensitive to a possible slowdown in global trade (see How Could the US Disease Infect Europe? by Eric Chaney, August 30, 2007).
Core inflation has been easing. The unemployment rate in the US, for instance, at 4.6%, is still some way above the low in 2000 when 3.8% started to create inflationary pressures, and the Fed fund rate reached 6.50%. In a more globalised world the US unemployment rate probably needs to go even lower than that before inflationary pressures are triggered. As long as inflation is not a big problem, rates can act as automatic stabilizers to the growth outlook and ‘solve’ the growth problem, as they have done for years now, time and time again.
Insiders have been buying, and that is bullish. At the end of August we reached the lowest insider selling / buying ratio since the end of 2002.
Quant model says we aren’t heading for a recession. Our quant model to forecast recessions tells us that we are 4 Fed rate hikes away from a recession. And remember, this model has predicted each recession since 1960, and has never given a false signal. The recent peak in this indicator at 50% at the beginning of April was significantly below the 70% threshold below which there has never been a recession. Remember, we use this as a binary indicator: below 70% there has never been a recession, above 70% there has always been one.
European earnings outlook good. We expect 9.0% EPS growth in 2007 and 6.5% in 2008, compared to IBES consensus expectations of 8.9% and 9.8%. We also recently introduced a quant model to forecast earnings for the next 12 months, our EGLI or European Earnings Growth Leading Indicator, in An Earnings Growth Leading Indicator for Europe, June 25, 2007). It takes into account five factors: US earnings growth, ISM New Orders, BNB Business Survey, German 10yr bond yield and Fed Funds target rate. It currently forecasts 17% growth, suggesting that there may actually be upside risks to our forecasts. Our take on this is that we will see downgrades in the next 6 months, in all likelihood, especially among Financials, but as long as EPS growth is positive a mid-cycle slowdown environment is bullish for equities through lower
rates.
Credit valuations are more reasonable now. In Sanity Check, May 23, 2007, we published a chart showing how irrational credit markets were. Credit markets were priced such that the weighted average cost of capital (WACC) gets lower with more debt, irrespective of how much debt a company has. Thus, a junk bond rating of BB gives companies the lowest WACC. In other words, no cyclicality of cash flows was priced in, illustrating excessive risk appetite. By now, the optimal point on the credit curve is BBB, followed by A, which is a much more stable situation. The investor we met in May who stated that February 2007 is to credit what March 2000 was to the NASDAQ shared a brilliant insight with us!
Authorities are reacting: central banks are injecting liquidity, and President Bush has announced some measures. We are moving through the usual sequence of events in a crisis. The end of such a crisis is when authorities step in to try to solve the problem. We are well into that phase. With core inflation having eased, there is room for more rate cuts, and they may indeed be needed to stabilize the outlook. Government Sponsored Entities may have to be allowed to inject liquidity and buy up some of the derivatives that are in trouble before a more stable situation in money and credit markets is restored. Ben Bernanke clearly illustrated he is aware of the severity of the situation in his recent Jackson Hole speech.
Many short-term worries. The appetite for LBOs and structured product certainly peaked in Q2. There is a large pipeline of leveraged loans to be placed (~US$500 billion according to Monday’s Financial Times), which hangs over credit market valuations. Real estate is overvalued everywhere. The Anglo-Saxon consumer will slow down. More financial losses will be uncovered — watch in particular the investment banks reporting. Money markets are severely dislocated still, and it is important that they stabilize indeed in the next few weeks, as we expect. Having said that, wages and employment growth are still good, companies have very strong balance sheets, and there is a lot of money around, looking to invest in public equity markets, or in distressed debt markets, including among the new and rapidly growing sovereign wealth funds and uninvested private equity.Recommendations:
Asset Allocation — Overweight equities (3% above benchmark), Neutral cash, Underweight bonds (3% below benchmark). With valuations attractive, sentiment negative and fundamentals likely to improve, in our view, we have turned buyers of equities on August 13 for the first time since January 22, earlier this year.
Sectors — see European Model Portfolio in Exhibit 34. We are now overweight Healthcare (see Making Pharma Our Biggest Overweight, July 2, 2007), Tech & Telco, and Financials (see Financials: Very Contrarian, Decent Value, But Risks Are High, September 3, 2007). We are underweight Consumer-related areas as both the valuation and the outlook for these sectors in general is not good, we think. We are neutral Utilities, Materials, Energy and Industrials, but if our more bullish scenario plays out, Industrials, Materials and Energy should do well, while Healthcare and Telcos may not deserve an overweight in such a scenario.
Styles - Large caps. We believe that 2007 was the start of a multi-year trend of large cap outperformance. The valuation case for large caps is very good, the growth outlook is now quite similar to smaller caps, and the strategic M&A and liquidity phase we are likely to enter now should benefit large caps more, as is often the case in the last few years of a bull market (remember the Nifty Fifty, and TMT?). See Super Size Me: The Case For Large Caps In Detail, May 14, 2007.
Quantitative stocks screens. If we were on the buyside, we would invest maybe one third of our money in quantitative stock screens that we believe in.
Our four favourite such screens are:
1) Benjamin Graham Value Stocks — What Would Benjamin Graham Consider Buying Today? August 6, 2007;
2) Equity Carry stocks — Equity Carry: Financials & Telcos Dominate, August 28, 2007;
3) The Magic Formula / Joel Greenblatt-inspired long-short strategy– What The Magic Formula Advocates Today, August 2, 2007, and
4) Private Equity Screen — Updating Private Equity and 3Us Analysis, April 10, 2007.
And that’s it.
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