Has the sell-off run its course?

Investing is not another science. It is not physics where actions can cause pre-determinable reactions. Some people would like to persuade you that it is; but they are wrong. If you wish to compare it to anything, it is more like tracking in a great wilderness of possibilities.

There are fundamentals and market sentiment! Occasionally they are correlated and synchronized; but the hare of sentiment often runs ahead of the trailing fundamentals. Those are the periods when sentiment is the trend and the ‘trend is your friend’; the times when so called ‘momentum’ investing is in vogue – or ‘herding’, as others like to call it.

The time when it is most profitable to buy shares is when the index turns up paradoxically, in the seeming absence of bullish news and the unlikelihood of any ever arriving. Those are often the occasions when sentiment has sprinted too far ahead of fundamentals, which are changing but yet unseen and taken hostage by outrageous fortune. Are we seeing an example of the phenomenon now? Are equities the best bet for big institutional funds looking for somewhere to funnel their cash flow? I ask the question because last Friday I was surprised to see that the FTSE100 Index had broken above its trend corridor of swings around the trend line itself. I was surprised because the mood of gloom was so deep and pervasive that I was not psychologically predisposed to such an unexpected omen of hope.

It seemed a paradoxical observation of a share price index when we have just been told that central bank interest rates cannot rise because the economic outlook for recovering economies in the UK and US is now too poor to justify such action! But here we are with equities not only moving up but, counter intuitively, also tentatively changing direction as well. Has the market bottomed out, having completed a sideways move, and now trending up? Have a look and see what you think of the chart.

Why should equities improve if the economies to which they are linked are too weak to justify an interest rate rise? The next step must be to look for some objective reasons as evidence to rationalise that conclusion. In short, what are the objective, relative attractions of equities at this stage? Do they have attractions; and if so, in relation to what? As Sherlock Holmes used to tell us “once you have eliminated the rest, what remains must be the truth, my dear Watson!”

The first thing to say is that markets are directed by big institutional funds, some of which, like pension funds, have long-term liabilities. For such funds there is the aforementioned fundamental risk of being out of the market, not in it. Because of that, they are constantly aware of the need to get cash into the market for fear of getting it wrong and – putting it gloomily – leaving fund liabilities “uncovered”. An upward market movement for a year often occurs over a crucial couple of weeks. Being insufficiently invested in those weeks damages long-term performance.

For the private investor, the reverse is the case: the risk for him or her is being in the market and out of cash.

The second thing to note is that the FTSE100 Index is currently more full of regret than profit. There is not much in the way of profits to take! No one is going to sell equities now en masse for that very reason. Quite the reverse! The FTSE 100 Index has fallen near 10.5% over twelve months. Moreover, the FTSE100 Index offers a dividend yield in the region of around 4.2% last seen (even if that is uncovered by earnings to the tune of there being only enough reported earnings to cover 87% of dividends, implying a covered dividend yield of 3. 65%). Looking at the broader market as a whole in the shape of the FTSE All share Index there is a dividend yield of 3% covered 1.3 times.

In contrast, the yield on 10- to 25-year gilts to redemption is a modest average 1% reflecting the absence of inflation expectations at the long end of the range and the plentiful supply of credit at the short end. The average yield posted for gilts with redemption dates out to five years is a near microscopic 0.46% – as practical matter of fact, a negative rate of return. Where is the conservative and pragmatic institutional investor to put the money?

Concern about the global economic outlook has been growing like bird flu. Consequently, the widely advertised timetable for a return to rising bank rates to tame economic activity in the US and UK has had to be withdrawn. The same economic uncertainty that is unhinging equities is also depressing bank rates and holding back any steepening of the of gilts’ redemption yield curve. Property is also generally providing low rental yield returns. So these do not seem obviously attractive at the moment.

All of this suggests that UK institutions with UK liabilities which drive all UK markets must be perplexed about what to do with their regular cash flow. I guess that on a “finger in the air” basis – to try and work out from which direction the wind is blowing – UK equities probably look more the institutional investment choice of the moment because they still give a decent income – which in turn will need to be invested for the same reason. Could it be that which has prompted the sudden buoyancy in equities and the aforementioned breakout?

Unexpectedly, prophets, soothsayers and economist magicians think they see some improvements in their crystal balls – as in a glass darkly. The man on the Clapham Omnibus reading his Financial Times would be forgiven for thinking that crude oil prices are still heading south to lower levels. It was not long ago that the all seeing and all knowing Goldman Sachs was reported to be forecasting that the price of Brent crude would fall to a modest, unprofitable (for many producers) $20 a barrel; others in the requiem chorus of doom and dismay, were singing out that it would actually reach $10 a barrel, such being the global imbalance between supply and demand for oil. Moreover, had the same chap on the Clapham Omnibus not also read in his pink financial bible that the Chinese economy was to slow yet again to a mere 6.5% per annum growth rate from last year’s claimed 7% per annum? And yet share prices rise?

The first rule of markets is never be surprised by the surprising; as I often say, the future is unforeseeable by mere mortals – even those on large pay packets. The second rule of markets is that forecasts are often unreliable – even when made by those who receive large salaries for doing it. The third rule is that oil prices are amazingly volatile and, in their extremes, pretty unpredictable. Within a matter of a year or two we have seen crude oil prices go from over $100 per barrel to $28 per barrel last month. Forecasts of crude oil prices have been even worse: the forecasts of oil prices have ranged from an unseen $200 a barrel to the aforementioned, recently forecast $10 a barrel.

So it should come as no surprise on the basis of the history of forecasting, that the grey clouds of forecasters myopia, suddenly part asunder, to reveal some now newly discovered, sunlit reasons for thinking that the oil price might head north to hit $40 a barrel again and that – totally contrary to recent belief – falling estimates for China’s GDP are no longer bearish for oil, iron ore or equity prices.  As China’s government lowered forecasts of annual GDP growth from around 7% to around 6.5% last Friday, equities moved better along with oil and iron ore prices. How can so many specialists be wrong? Fortunately, it is their failure that makes investing an imperfect but potentially profitable business.

Investors, bearing all this in mind, should cling to the wreckage of market equity capitalisations and emerging value as share prices go lower. Dividends are one of the mainstays of equity value along with such things as ‘price to book’ value.

Do your investing that way and you will have the right end of the stick. If you see value, that is usually a more reliable investment objective than listening to fathomless warnings and forecasts about an unforeseeable future. That I hope shall continue to be my approach, until somebody finds a better one. In my next piece on markets and the economy I shall analyse further the arguments for now being more bullish than bearish.