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Over the last 14 months equity investors have experienced a rollercoaster ride as markets have seen three corrections. Implied S&P volatility, indicated by the VIX, or CBOE Market Volatility Index, level has reached a high not seen in recent times. Many believe we have entered a permanent phase of higher volatility for equity investors - this means that, although equities may still be the best place for superior returns over time, investor risk tolerance will need to be higher.
Volatility is two directional and as we have seen recently, the markets have had strong up days as well as strong down days. This means that an investor who remains bullish on the market, for the longer term, will need to remain invested during market drops or run the risk of not re-entering the market in time to catch the recovery.
So, what's going on? The recent broad market decline has been influenced by several factors. For months, economists, investment strategists and central banks have been minimizing the effect of the US subprime mortgage crisis on the broader local and global markets. Fundamentals seemed intact and the subprime mortgage crisis was already old news. So, what happened?
The Ripple Effect. The US subprime mortgage market is approximately 10% of a $10 trillion mortgage market. The market has been experiencing a rise in the default rate and an increasing number of mortgage brokers in this sector have been declaring Chapter 11 (bankruptcy). The effect of a rising default rate spilled over into the private equity sector; private equity funds had been using relatively cheap financing to leverage mergers and acquisitions of publicly trading companies on Wall Street and in European markets. Credit began to tighten as bank balance sheets were impacted and financing became more expensive. Investors became more apprehensive as they saw more concrete signs that perhaps the subprime mortgage crisis was not as contained as claimed by Wall Street and others. This raised concern since part of last year's and this year's impressive gains for equities were a result of a tremendous upsurge of M&A activity. Now, all of a sudden, the credit spigot had been shut off.
Ripple to Snowball. Investor sentiment has become negative on higher risk asset classes. Markets most impacted have been emerging markets debt and equity as well as high-yield debt. Developed markets have faired better but still remain under pressure. Recent announcements of major problems with known hedge fund managers (e.g. Bear Sterns, BNP Paribas, Goldman Sachs etc.) have increased investor apprehension about the effect of the funds' need to close positions; therefore increasing market volatility.
Market Fundamentals Make an Interesting Case for a Brighter Day Around the Corner. It is clear to me that this market is driven 30% by fundamentals and 70% by investor sentiment. Herein lies the risk. If investor sentiment does not reverse course, we could witness further damage to global markets. But there are some compelling considerations to expect emotions to calm down over the next few weeks.
Liquidity Crisis Over or Just Beginning? Investors tend to overreact in both down and up markets. We in the business call it "overshooting." You could compare it to euphoric and depressed states of mind. Clearly we are in the latter. But, let's take a look at some interesting data. Last week the Fed and European and Japanese central banks acted to reassure the markets that they would infuse funds to maintain liquidity. The first effort actually surprised the markets by raising concerns that situation may even be worse than suspected. However, the second round of cash infusion achieved a partially calming effect. Still, the major threat to liquidity is probably more an issue of investor risk aversion than lack of cash.
M&A Activity Will Rebound Though Not to the Previous Level. Though before the recent crisis it was projected that private equity funds had over $1 trillion to invest in M&A activity, recent reports indicate that over $400B still remains in the coffers of private equity funds for this activity. In addition, US and European corporations have very healthy balance sheets with significant cash reserves. This is important to understand for two reasons. During the recent round of M&A activity, private equity funds were willing to pay for higher valuations than corporations to acquire companies, effectively pushing them to the sidelines. Now, with reduced private equity liquidity and lower valuations on publicly traded companies, we can expect to see corporations making up for part of the reduction in private equity M&A activity. Also, as credit has become tighter, these cash rich companies will be better able to continue operations and borrow at preferred rates.
Are Equities Still Attractive? Fundamental analysis of US and European equities suggest that many stocks may be trading from fair to undervalued. The S&P is trading at under a 15 P/E, which last occurred in 1991. European equities are trading at a 25% discount to their average P/E over the last eight years. US corporations just concluded their quarterly reporting season with 80% of the companies surprising analyst forecast on the upside. Wall Street analysts are estimating between 9-11% growth for S&P 500 companies over the next 12 months.
The issue may not be so much if equities are still attractive, but rather which equities? Investors who desire to remain in stocks, but desire less downside risk, may want to consider rebalancing their investment portfolios away from small cap stocks and more heavily weighting their portfolios with large cap growth stocks with healthy global activity as well as dividend oriented companies. Although emerging markets still remain attractive, a defensive investor may want to significantly underweight this exposure.
What About Fixed Income? Interestingly enough, though some fixed income asset classes suffered in this current environment (emerging market debt, high-yield bonds, CDOs, etc.), there has been a flight to quality resulting in positive returns for high-quality, mortgage-backed securities as well as high-grade corporate bonds.
Hedge Funds Are Not All the Same. When investors hear of a hedge fund disaster, there is a tendency to lump all 10,000+ hedge funds together for risk considerations. The true situation is quite different. Many hedge funds have and will weather the current market environment. Some will actually post positive returns. What is most important to remember is highly leveraged funds and funds heavily exposed to low-grade mortgage-backed securities will be threatened in this environment. Computerized trading funds are also showing signs of duress due to short-term market volatility. Investors who desire a more conservative approach to hedge fund investing should continue to invest through multi-strategy and fund of funds hedge funds.
Economic Fundamentals Still Look Sound. My final comment is about the US economy and beyond its borders. Economic indicators suggest that the US economy continues to grow at a 1.5-2% rate. Inflation appears to under control, and the Fed most likely will be reducing rates in September. Unemployment remains at an historic low, the US trade and budget deficits are both narrowing. Europe's GDP growth continues at a +2.5% rate and inflation seems to be calming down on the continent, as well. As long as US employment remains healthy, we can expect continued economic growth.
Climbing the Wall of Worry. Fundamental analysis makes a strong case for remaining in equities in 2007. Equities still look more attractive than bonds, but investors will have to pay the price of increased volatility. Of course, the one unquantifiable issue that may cause the markets to continue in a negative direction is investor sentiment. So tell me, how do you feel about it?
The author is Global Investment Strategist at Tandem Capital. [email protected]