If, like me, you were on holiday during the US sub-prime market inspired equity crisis in August, a glance at the current levels of the London and New York markets might lead you to think, momentarily at least, that very little happened while you were paddling in the sea. It is unlikely, however, that you were able to ignore events for long. And the frayed nerves of some investors (it has to be said mainly institutional) who stayed at home while the FTSE dived 900 points, is testament to the writing of a footnote in stockmarket history. There is every reason to beware of summer turbulence as it is often to be seen at the tail end of a bull market. The question remains as to whether this episode will develop from a footnote to become a sub-chapter or worse. So just what happened and what approach should investors now take?
For all their global power, markets can be easily frightened and there are a number of words which make investors fear they are out of their depth. ‘ Bubble’, ‘uncertainty’, ‘mistrust’, ‘poor transparency’, ‘imperfect information’. Each of these, to some extent, can be used to describe recent events. In the US a lending frenzy has resulted in a raft of loans to the sub-prime (or high risk of default) sector. This debt was subsequently packaged and re-sold internationally. Higher risk financial instruments created, bundled and sold on as opaque low risk products (abetted this time by the credit rating agencies) has been seen before and it’s rarely pretty, resulting in an inefficient market with an inability to correctly discount risk – remember Lloyds of London and even the zeros affair. The problem here is that what was a few weeks ago a vibrant market has dried up; become illiquid because no one yet knows if the instruments held are high or low risk and not unreasonably are unprepared to buy until it unravels. And this will only happen as the hedge funds (who themselves have financed their vast equity acquisitions on the back of this now scarce cheap credit) begin to report. Meanwhile, the UK inter-bank rate (the rate at which banks lend to each other) reached a 20 year high. It is this environment which has hit Northern Rock.
The new buoyancy in markets is a direct consequence of the Federal Reserve decision to cut the US discount rate, corresponding moves by the European Central Bank (although the Bank of England, notably, did not follow suit) and the belief that the Fed will continue to bail out financial markets almost irrespective of wider economic conditions. Again there are historic parallels – remember the ill-fated Lawson boom following the 1987 stockmarket crash when interest rates were dropped out of misjudged panic that a recession would follow?
Naturally, policy makers are aware that, so far, the crisis has remained one confined to the financial industry (albeit on a global scale). Should it spread to the so called ‘real economy’, where we all live, work and shop, new pressures could be felt on equity markets. It is a delicate process which is likely to lead to more volatility since the likelihood of further rate cuts is in direct disproportion to market levels.
So where are we? Markets are currently characterised by uncertainty and imperfect information and yet long-term equity returns remain solid and price earnings ratios have improved. Analysts are divided as to whether the bull market has much room to run. But short-term volatility provides opportunities to fish for bargains, buying quality at a discount. We are in the un-chartered waters of a market shakedown which means it is time to reassess risk and attitudes to it. Pick quality investments that have a good risk return profile and have confidence in decisions.
‘Sell in May and go away’ they say. How many of us did that before we packed our snorkel and headed for the beach this summer?
You can read more on the topic by downloading The investment review Stocktake available from the Research Section of the Selftrade website www.selftrade.co.uk.