Equity Markets

1.   Expensive markets

By simple definition, a drop in the S&P PE ratio from a historical 30, to a projected 16 represents a correction of -46 %. The last month has seen markets return to far more realistic levels.

2.   Earnings quality

When Enron collapsed, the world was shocked. Then came Tyco, Merck, K-Mart and Worldcom - to mention but a few. Gradually investors have come to accept that accounting irregularities appear to be the norm rather than the exception. It appears that it had become 'generally acceptable' to manipulate earnings across corporate America.

US Earnings: Can you believe what you read in the papers?

In 2001, NASDAQ 100 companies reported combined losses of over $82bn to the SEC while reporting profits of $19bn to Shareholders. This has brought the concept of core earnings to the fore. 'Core earnings' strip out most of the earnings enhancing tricks. These relate to Share option schemes, restructuring charges and exceptional items. As an example, General Electric reported EPS of $1.42 for 2001. 'Core Earnings', however, were revealed to be $1.11 per share, roughly 20% below the initially reported figure! This is probably indicative of the current state of US corporate earnings, i.e. roughly 10-20% overstated which means the US markets are probably 10-20% more expensive than they currently appear, and investors are increasingly beginning to accept this.

(Chinese investors should fortunately experience less manipulation following their sentencing of a former brokerage chief to death for misappropriating public funds!)

3.   Budget deficit

The third very real risk highlighted was the 'US budget deficit', which has ballooned to $500 billion. With their powerful dollar, the Americans have essentially been able to "buy the world", which is exactly what they have done. As a result, imports rocketed whilst exports became less competitive and fell. Funding the deficit was easy whilst the world poured their money into the US during the late nineties. But with funds now leaving the US, the dollar is unwinding and is vulnerable.

4.   The economy’s strength is partly artificial

The world heaved a sigh of relief when, after negative growth in the 3rd quarter of 2001, the US experienced positive growth in the 4th quarter, thereby miraculously escaping a recession. The world was, however, amazed by the first quarter growth of over 6%.

America keeps on spending...

The spending is, however, not being incurred by US corporates, who have cut back significantly on capital expenditure. Spending has come from the US government and the US consumers who, with interest rates at 1.75%, have borrowed themselves into record territory. (Wouldn’t you buy a bigger house and car at similar levels?)

But, the spending can’t last...

And that is Greenspan’s dilemma. In order to save the US, he dropped the Fed Funds rate to unusually low levels and he now should start raising them without ‘throttling’ the 'over-indebted' US consumer to the point where they stop spending - which would weaken US earnings.

According to Chris Carter of Investec, this will see US interest rates remaining artificially low for longer. If the economy continues to weaken, we could even see a 50bp cut, as Greenspan desperately tries to avoid any chance of a "double dip" recession.

5.   Panic

The final risk that US markets currently face is investor panic. The markets have seen heavy sell offs over the past few weeks, and the risk is that we reach a point where US investors opt for capital preservation and switch 'en-masse' out of US equities into cash and bonds. Further geo-political and terrorist attacks would also cause panic.

Summary

In summary, therefore, the recent sell-off should come as no surprise. For roughly a year we, and other market commentators have been warning that US markets are very expensive, that the US dollar is overvalued and that the US fundamentals are not what they were in the late nineties. Investors have learnt previously with the technology collapse (and with Small Caps in SA), that when market consensus increasingly calls markets overvalued, that eventually they will correct. Fear builds and eventually the catalyst (in this case accounting scandals, in particular Worldcom) forced the correction.

What you are seeing is a natural retracement of US markets to more reasonable levels. Already on a PE of 30, the S+P 500 is looking a lot more realistic, and increasingly market commentators will start calling the markets more reasonably priced and the selling should abate. Whilst panic is not impossible, at this stage it appears unlikely.

Recommendation

Tempting as it might be, trying to time these markets is near impossible and whilst there probably will be further downside, investors would probably be better to sit it out. For those who believe significant downside is likely, our "Classic Port" for local money, or "Porto" for global funds provide an attractive alternative to global equity turbulence.

SA equities, on a PE of roughly 10, should experience limited downside from these levels, and investors wishing to build up a position in domestic equities should start phasing funds into current weakness, a strategy which we have been recommending for some time now. It would not make sense to buy directly into this market just yet, however, a 3 – 6 month phase in could deliver attractive returns over the next 5 years.

Lastly, on the global front, an attractive alternative would be a product such as the Cadiz Euro Lock-in fund. This fund guarantees your capital in Sterling, whilst investing in a portfolio of heavy weight shares priced in Euro. What does make this very attractive is the mere fact that most of the 15 shares in this basket have all dropped by between 20% and 40%. As we all know, the markets WILL rebound, and over the next 5 years we should see realistic growth out of this fund. If you need any further information on this, feel free to give me a call.