Last week, the Financial Times quoted Bob Doll, the chief investment officer of Merrill Lynch Investment Managers, as saying: "There are more people saying, 'I'm afraid of the downside.' You see investors' fear in the amount of cash they hold and the scepticism of their questions."
Doll goes on to make a good argument for his bold investment stance towards United States equities, which will make more conservative market followers shudder. This from a man who works in a city that has recently been plagued by terrorism.
It was a refreshing read among all the terror-related articles that have dominated the press in England. It made me realise how, at times, the market seems to shrug off shocks, while, at other times, the aftermath lingers. After the September 11 attacks in 2001, the markets in the United Kingdom and the US (measured by the FT100 and S&P 500 indices) fell and took a long time to recover. In fact, any purchases made by investors just before September 11 are now worth about what they were then, having declined and recovered over the past four years.
It is early days following the recent attacks in London, but world markets seem to be holding their own. Can this time be different? Can we detect a pattern of recovery and circumstance when crisis strikes?
I believe the answer lies in the underlying value offered by the market at the time the crisis occurs. Let's look at the price:earnings (p:e) ratios of the two markets in question. You generally need to make an assessment on the absolute level of the p:e relative to history and the current economic outlook, and also on the p:e relative to other asset classes.
In September 2001, the UK and US market p:e's were 20 and 30 times respectively. Currently, they are 15 and 20. This may seem a little high in absolute terms, but these are their lowest p:e's since 1996! A tick in favour of the bulls.
You can then compare the earnings yield (the inverse of the p:e ratio) of the market to other asset classes, such as bonds. In both the UK and the US, the earnings yield of the stock market is higher than the yield offered by long-term government bonds. This differential has been creeping up over the past decade, and is near a high for the past 12 and 17 years for the UK and US respectively.
The yield at which they are currently trading indicates your buy-and-hold return for government bonds. The stock market, however, offers the potential for capital growth, albeit together with more risk. If the stock market is offering you a higher yield, you can argue that either the stock market should be higher (bringing the yield down) or bond yields should be higher (meaning your investment in bonds will decline).
If you think bond yields are at a comfortable level and there is not too much risk of them rising, you should favour shares. If you think bonds are expensive and that the yields will go up, the argument is unclear - either equities or cash is preferable.
What is the situation in the South African market? Currently, our long bond rates are trading at just over one percent higher than the earnings yield of the share market. For most of the 1980s and 1990s, equities traded around seven to eight percent below bond yields. That means that bonds used to offer a yield that was seven to eight percent higher than the earnings yield of the share market.
In case you want to jump into the stock market boots and all and relinquish all other asset classes, remember that the big difference between the 1980s and today was a higher inflation rate. This caused many investors to favour the equity market, causing the differential to open up even more. Once the reality of lower inflation kicked in, bonds out-performed equities for a long time. This resulted in many bond teams gaining prima donna status and finally being given an opportunity to speak at fund managers' morning meetings all over the country. Eventually, the good news spilled over into the equity market and a re-rating has taken place there too.
So, lower inflation is actually good for both asset classes, and if it is accompanied by good growth, it is really good for equities. We've seen the bond run (perhaps not all of it), and equities have done well. But relative to bonds, equities still look great when we recall that seven percent differential of the past. Or do they?
I'll pursue that issue next week.