Monday, December 10, 2007

A strategist worth listening to

Here's something from the Financial Times:

Investors should shut their ears to the bears

By John-Paul Smith
Published: December 9 2007 19:25

"As I watch the wild gyrations rocking the world’s capital markets, I wonder what it was that I ever liked about this job. I have been an investment manager for nearly a quarter of a century and can recall seeing these types of extremes only twice before, with the 1987 crash and the 1999-2000 technology bubble.

The financial sector is now priced for the worst-case scenario. US 10-year bond yields are well below the dividend yields of strong, well-capitalised companies, notably in the pharmaceutical sector, while almost any US consumer-related stock has fallen dramatically. On any assumption, except prolonged deflation, equities look dirt cheap relative to bonds. The dollar has fallen by more than 40 per cent against the euro and, across financial markets, momentum investors have been handsomely rewarded against value investors. Meanwhile, commodities and emerging markets enjoy close to safe-haven status and trade near all-time highs. US subprime lending to largely uncreditworthy clients will leave a trail of bad debts across working-class America.

But this group of householders is small relative to the size of the US housing market and to the overall economy. Consumption in today’s highly unequal US society is dominated by the nation’s top earners, while the bottom 10 per cent account for less than 1 per cent of total consumption.

The real reasons behind the profound effect on financial markets of the subprime turbulence can be found in the psyche of market participants and observers, notably in their deep distrust of capital markets, which dates from the trauma of the tech bubble.

By the end of the technology bull market the reputation of the entire financial services industry was in tatters. Analysts’ reputations suffered most of all through their conflicts of interest and their reluctance to put sell recommendations on stocks they privately rated in a more derogatory way.

We have come full circle from that heady spring of 2000. “Bubble” is an overused metaphor, but I think commodities and emerging markets occupy almost exactly the space in both investors’ portfolios and their psyches as did tech industries seven years ago.
The intellectual foundations of the commodity boom are pretty shaky: even before action on global warming, energy intensity levels in developed countries are declining and there is a tendency over the very long-term of real commodity prices to decline.

Meanwhile, emerging market equities are now rated at parity with their developed market counterparts, despite having far greater historical earnings cyclicality and signs of bubbles in the Chinese and Indian stock markets.

Previous cycles teach us that we should always start with price. While the secular story may be valid, if the price is wrong, stay clear. In the US, the price of its currency, equity markets and even property is very attractive indeed, at least from this European’s jaded perspective. Nasdaq is now selling at about 26 times prospective earnings, compared with well over 100 times in early 2000 and around 50 times currently for the domestic Chinese index. If you think US banks have problems, they are nothing compared with what is most likely buried away in the balance sheets of the big Chinese state-owned banks, which is one reason why the authorities are so reluctant to let the renminbi appreciate.

I believe that the current consensus owes more to the short-term collective psychology and incentive structures of market participants than to an objective long-term analysis of the corporate and economic fundamentals. There have been three key changes.

First, the rise of hedge funds has led to a big increase in shorting. Second, most fund managers are incentivised around, most often, one-year performance. Finally, sell side analysts are now rated more for their buy/sell recommendations than for their detailed company and industry knowledge; their advice is based largely on the predicted reaction of investors to future newsflow than on fundamentals. I have a hunch that we are through the worst of the fear surrounding subprime and that, although the US housing market will continue to deteriorate, the dollar will begin to recover once investors realise that the long-term prognosis for the US economy is actually very good, as evidenced by its high productivity and positive demographic trends.

The almost perfectly correlated long commodity and short dollar trades should soon begin to unravel. Emerging markets are likely to enter a relative decline with sharp divergences in the individual markets. The US is due to begin a long period of outperformance, led by a rising dollar and a sharp rally in financials followed by technology and pharmaceutical sectors.

In early 1999 I told investors to buy Russian equities. In 2001 and 2002 I tried, largely unsuccessfully, to persuade investors to go very long on emerging market equities. My advice now is similar: shut your ears to the cacophony of bearish comment and negative newsflow and think longer-term."

The writer is chief strategist at Pictet Asset Management


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