Equity markets: Is it too late to be selling?

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By Shaun le Roux

This time last year the stock market was bullet proof. We were focusing a lot of our attention on trying to persuade clients to tone down their one- to two-year expectations from equity markets. Yet, at a point in October 2007, the JSE All Share was trading at 31,500, 26% above its levels of 31 December 2006. Right now, it is still trading 10% higher than it was in December 2006 after experiencing a 13% correction in recent weeks. It is worth pointing out that a hefty proportion of shares on the JSE are trading lower than they were at the end of 2006.

Investors in equity markets over the past four-and-a-half years have enjoyed fantastic returns – in fact the best real returns since the 1960s and this bull market has been characterized by very low volatility, with 10% plus corrections virtually non-existent. This is why current market conditions may feel like uncharted territory for the myopic masses that only have the bull market of recent years as a frame of reference.

The last few months have seen a swing in sentiment on financial markets: global equities have been decidedly weak and are busy undergoing a healthy correction, volatility has increased significantly and markets are clearly nervous. At the same time, headlines in the financial press have become decidedly gloomy. At home retail spending has hit a wall, new car sales are dropping precipitously, food and energy inflation is rampant and household spending has been severely curtailed by a 4% increase in bond and car repayments. Across the ocean, the US economy is teetering on the brink of recession while the UK, Europe and Japan are also looking vulnerable to major slowdowns. After many years of excessive financial engineering global banks are working their way through a credit crisis that looks like it has much further to run. Technically, it looks like a bear market in US equities has commenced.

No wonder investors are starting to worry and financial advisors’ phones are ringing off the hook. The question (and temptation) is clearly: “Shouldn’t I be selling my equities? My portfolio is still healthily up over the past few years and now that the markets are looking choppy I’m much more interested in preserving my capital.”

It is worth remembering that stock markets discount both good and bad news and that stocks have already priced in much of the gloomy headlines. Cast your mind back to March of 2003. Back then the financial markets had been hammered and the financial press was being dominated by the post-dotcom rout on equity markets, the war in Iraq and the profit recession on global markets. Pessimism abounded at that time, but this laid the foundations for the returns of recent years.

The risks around equity markets are clearly higher now than they were a year ago. Notwithstanding, investors are starting to be compensated with the fact that most shares are much cheaper now than they were then. On the local front, domestic financial and industrial shares are well down and are starting to look like extremely good value. We would expect to make very good returns from this area of the market once the interest rate cycle peaks. Commodity prices are holding up well with precious metals and oil rocketing at present. This bodes well for the SA economy and corporate earnings from the Mining sector, hence the JSE.

For some time markets have offered reduced return prospects while risk levels have been elevated. This has seen most asset managers and financial advisors positioning client portfolios more conservatively, as we at Alphen have done. These higher levels of cash in the asset allocation portfolios have served clients well over recent months. We continue to beat the drum that all of our work points towards clients being better served by adopting an asset allocation solution over time that matches their risk-return profile, than by trying to time entry and exit points into the market.

We are not struggling to find cheap shares. Currently we feel that the best value lies in the bombed out domestic plays. If, as we expect, the SA economy continues to grow at a reasonably healthy rate, it is difficult to see earnings contracting by enough to justify current valuation levels. As a result we expect this part of the market to provide very healthy real returns over the next three years. These shares may go lower, but now is certainly not the time to be selling and we would recommend that clients start accumulating instead. The good thing about uncertain and fearful markets is that they are the breeding ground for opportunities to make excellent returns without assuming dangerous amounts of risk.

Markets could well go lower over the months ahead and in their current mood this looks like it could well be the case. This is exactly the time that clients should be glad that their money is being managed by professionals who lie awake at night and worry on their behalf. They should take comfort in the fact that their investments have been structured to weather this kind of market turmoil and provide them with the appropriate growth over the period of their investment horizon, and not on a daily, weekly or monthly basis.

Source: Shaun le Roux, Alphen Asset Management, January 14, 2008.

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