Bear markets are never fun

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By Shaun le Roux

Equity markets around the world are struggling. Most markets are down in 2008 and are not significantly above their lows earlier this year. The Shanghai Composite in China is more than 50% down on its October 2007 high.

Equity markets have had to grapple with a toxic combination of slower profit growth on the back of weaker economies and rising inflation. The US has been forced to slash interest rates and this has had the effect of stoking the inflation fire via high and rising commodity prices. Loose US monetary policy is imported into the developing nations where growth in demand for commodities is strongest which partly explains the high levels of food and energy inflation. Furthermore, investment demand for commodities is strong – they act as an effective hedge against inflation and a weaker US dollar.

Equity markets never like inflation and they positively loathe stagflation. It is worth remembering that the almost 18 year bull market on the Dow Jones between 1982 and 2000 coincided with benign inflationary forces and low interest rates.

South Africa is suffering from a souped-up version of the same themes. Our inflationary pressures are especially acute of late. The latest projection by the Reserve Bank sees CPIX peaking at 12% in the third quarter of 2008 and only returning to the target range by the third quarter of 2010. Interest rates have been raised ten times and a cumulative 5% in two years, with more rate hikes expected in months ahead. The result has been a severe crimping of domestic demand and economic growth forecasts continue to be revised downwards.

Domestic equities have received a battering, particularly the financials, retailers and other cyclical consumer stocks. A large number of shares including some of our better known domestics are more than 40% off their highs of last year. In fact, according to Bloomberg last week only 76 out of the 370 shares they track on the JSE have gained in price this year. 287 shares are down in 2008, most sharply so. This implies that about 80% of the shares listed on the JSE have lost money for investors this year. Earnings forecasts for the next few years for domestic industrial and financial shares have been on the receiving end of an aggressive haircut. But, not only are higher interest rates impacting on levels of consumer spending and profitability but they also result in lower share price values as the rate at which future cash flows are discounted rises.

The speed and extent of the slowdown in consumer demand caught many businesses in South Africa napping. They were in the process of rolling out capacity to meet further anticipated growth in demand. The combination of weak demand, higher finance costs and input cost pressures has given rise to the abrupt wobble in corporate profits. While earnings have been light in many cases, a noteworthy element of some recent results announcements has been disappointing dividends.

Here, I refer you to Nampak’s recent results. Nampak has been a perennial disappointer but retained a strong following amongst investors attracted to its stable and high dividend yield. In its recent interim results, Nampak cut its dividend signaling a further cut in its full year dividend. This will be the first cut since I-Net share data for Nampak commenced in 1982! Besides being symptomatic of poor trading conditions the cut in dividend is a indicator of financial stress emanating from a very low dividend cover, high levels of gearing, rising finance costs and a growing working capital burden.

Of course, the boom in commodities has very effectively insulated the resource-heavy JSE from the global equity bear market and we have often discussed the bi-polar nature of the JSE All Share. However, this particular commodity cycle is quite long in the tooth and even the Resource shares will peak out at some point in the future, if they aren’t in the process of doing so currently. Under those circumstances the JSE will likely find itself suffering some of the woes afflicting other global equity markets.

Yet, to our minds, the very clear silver lining that is emerging in this sandstorm of despair is the value that is emerging within pockets of the equity market. Stock markets are very efficient discounting mechanisms but they always have a tendency to overshoot both to the up and down-sides. It is always the case that it is difficult to commit capital to the stock market when all the news is so gloomy. But, without exception the best and lowest risk returns are to be had when “there is blood on the streets” as Rothschild put it. Many of the stocks we cover are at very attractive valuation levels. We don’t anticipate a rebound in the near future but we remain of the view that the next few months will present a very attractive entry point for those that are fortunate enough to have capital available.

Source: Shaun le Roux, Alphen Asset Management, June 18, 2008.


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