Financial Times- Why stocks are still rallying
Stocks are rallying like there’s no tomorrow, emerging markets are “on fire” - and in a Wednesday analysis of market trends, the FT’s John Authers finds out why.
First, the scene: As fresh news of severe losses by financial giants UBS and Citigroup on Monday revealed even more damage inflicted by this summer’s credit squeeze, the reaction of stock markets was clear. They rallied, notes Authers.
In Monday’s trading, the Dow Jones Industrial Average, still the most widely watched gauge of the US stock market, topped the all-time peak reached on July 19. This was broadly representative of the most important developed market indices. The US S&P 500 index and Germany’s Dax index are within 1 and 2 per cent respectively of their mid-July highs.
Neither the S&P nor the Dow have closed as much as 10 per cent below their highs since July. Thus, technically, they never even suffered what analysts would call a “correction”, notes Authers.
Meanwhile, as readers may have noticed, emerging markets are “on fire”. The MSCI Emerging Markets Index is up more than 50 per cent over the past 12 months, and has leapt by more than 25 per cent since August 18, the day the Fed cut the rate at which it lends to banks. The biggest emerging markets have rallied even though they were “already in nosebleed territory”, he says; in dollar terms, China’s Shanghai Composite is up 416 per cent since the beginning of last year, India’s Sensex is up 112 per cent, and Brazil’s Bovespa is up 133 per cent.
All of this has been achieved in the face of credit market conditions that have made finance much more expensive for companies, Authers notes. Cheap credit had been seen as a key factor in supporting equities, but now this crutch has been removed nobody seems concerned.
The rally also comes amid exceptionally tight conditions in the money market, which suggest that the big banks at the heart of the world’s financial system are still anxious. Further, gold has just touched a 27-year high.
So why are equities rallying? The instinctive reaction of many in the fixed income markets is to put this down to stupidity, says Authers. “Equity traders simply do not know what they are doing, or at least do not understand the ramifications of the damage that has been done to the structured credit market”.
But there are more rational reasons for the equity rally. First, and most importantly, the Fed:
Rate cuts tend to be good, at least initially, for stocks. If they are not, it is because they tend to coincide with the start of a recession. But the Fed’s action last week was plainly inspired less by worries about the economy than by a concern to avert a crisis.
Recent history, in turn, suggests that such “emergency” rate cuts by the Fed have the effect of inflating asset price bubbles. That is potentially great news for equity investors.
In October 1998, when the Fed under Alan Greenspan was forced to cut the Fed funds rate to bring back liquidity to the markets after the near-meltdown of the LTCM hedge fund, the result was also to stimulate markets that had not needed the help, Authers reminds us.
Large technology stocks, and the growing wave of dotcoms, were the greatest beneficiaries. The Nasdaq Composite index gained 40 per cent in three months, and tripled in less than 18 months as it roared through 1999. This, he says, helps explain the current reference to stocks as “partying like it’s 1999″.
There is another example, he notes: In 1987, after Greenspan’s Fed cut rates to avert a crisis in the wake of the Black Monday stock market crash, the response was again a bubble.
Traders know that both these incidents created bubbles that eventually burst. But they also know that in both 1998 and 1987, the euphoria created by the rate cuts lasted more than a year — plenty of time to make strong short-term profits, notes Authers.
Teun Draaisma, European equity strategist at Morgan Stanley, advocated selling in June, and then aggressively re-entering the market in August, for exactly these reasons. He says another bout of ‘equity mania’ is possible, with retail investors piling in and companies indulging in strategic mergers and deals.
He also predicts that the episode will “end in tears” — but that still leaves time for investors to make fat profits in the interim.
As everyone is working on the same assumptions, gains could be limited this time, Authers warns. Tobias Levkovich, US equity strategist at Citigroup and a bull on the market for most of this year, sounds a note of caution. “As most investors are now searching for performance data on past beneficiaries of Fed actions, we suspect some ‘institutional herding’ may arbitrage away much of the opportunity fairly quickly”, notes Levkovich.
The Fed itself is also acutely conscious of what happened in 1999. If crisis in the money markets is indeed averted, the Bernanke Fed might well move much quicker than the Greenspan Fed did to raise rates and avert the risk of a big bubble.
A second, perhaps more solid reason for the equity boom comes from corporate earnings, according to Authers:
Profits made by S&P 500 companies grew at a clip of 10 per cent or more for a record 14 consecutive quarters, until that streak ended at the beginning of this year. But results for the 2007 second quarter - published to little attention as the credit crisis was intensifying - remained very robust, with an increase of 8.7 per cent, much ahead of expectations.
Now, expectations for the third quarter, just finishing, are very low indeed. According to Reuters, analysts expect a rise of only 3.3 per cent year on year for S&P 500 companies. Many are betting that it will be easy to beat those expectations and land a surprise.
However, expectations for the fourth quarter and beyond suggest that analysts are banking on the credit squeeze to blow over completely, and for the US to avoid recession. According to Reuters, they are expecting growth of more than 11 per cent both for the fourth quarter and for the first quarter of next year.
These numbers could turn out to be wildly optimistic in the event of a consumer-led slowdown in the US, which looks a real possibility. If growth is this strong, moreover, it would seem likely that the Fed would raise rates.
A third reason for optimism comes from the most popular valuation systems, says Authers . “They all suggest that stocks are cheap”.
The price/earnings ratio on the S&P 500 has dropped to its lowest level since 1996. The p/e on the UK’s FTSE 100 is similarly at its lowest level in more than a decade, he notes.
Another popular valuation system involves comparing earnings multiples on stocks with the yields on government bonds - often called the “Fed Model” because at one point Mr Greenspan himself appeared from congressional testimony to be using it.
Bond yields have dropped sharply over the past few months and so, this model makes the stock market look like a very appealing “buy”.
There are strong theoretical arguments against both these valuation models, says Authers.
Profit margins tend to be cyclical, and appear to be peaking. Earnings multiples, in turn, tend to be lowest when profit margins are high. Thus, some analysts would say current low earnings multiples simply show that the market wisely does not expect corporate profits to continue at their current heady levels.
Another reason cited for optimism is that companies have been heavy buyers of their own stock (using cash, generally, rather than debt) to boost their earnings per share. This buying picked up during the crisis.
A further driver, says Authers, is the weak dollar. “In many ways, the rally is a bet that the dollar, already at all-time lows following the rate cut, will fall further still.”
Meanwhile, for US investors, continued falls for the dollar make international investing look more profitable. For example, Germany’s Dax index is up 28.6 per cent in dollar terms this year, and only 19.2 per cent in euros.
With the Fed cutting, the dollar lost critical support. One of the simplest ways to bet on further falls for the dollars was to buy emerging market equities and switch out of smaller companies into multinationals.
This ties in with a final theme that has sustained equities, says Authers: faith in the story of secular growth in the emerging markets remains intact. According to Emerging Portfolio Fund Research of Boston, last week alone $5.53bn went into emerging markets funds, the strongest inflows in almost two years.
Mining and materials stocks, most exposed to demand from emerging markets, have performed best during the rally: consumer discretionary stocks, vulnerable to a consumer slump in the US, have done worst.
So the boom in equities is more than a rally based on the belief that cheaper money from the Fed will be enough to avert a systemic financial crisis, concludes Authers:
Equity investors are also betting that growth will come more and more from the emerging markets, which successfully “decouple” from the US, while the US economy will continue to weaken. And they are ready to pull their money out as soon as the bubble seems ready to burst.
