Sure enough, the FTSE-100 index swiftly fell to a session low of 5338.7, the lowest since the end of October 2005, before embarking on a roller-coaster ride through the afternoon until the Federal Reserve surprised everybody by cutting interest rates (ahead of its scheduled meeting at the end of January) by 75 basis points.
But even before today’s excitement, such had been the extent of the correction in global equity markets, that the case for increasing equity market exposure had become overwhelming. Take the chart above for example, which shows the dividend yield ratio, our favourite valuation measure of the UK equity market. Throughout the last six months we have been arguing that UK equities were expensive, in that the yield ratio had moved above our “fair value” range as determined by the experience of the late 1950s/early 1960s. This more than anything else drove our decision to significantly underweight UK equities during the second half of last year. However, following the correction in share prices, all of a sudden UK equities look interesting again, with the yield ratio dropping back in to the bottom half of our fair value range. Given this, it was a straightforward decision for our Asset Allocation Committee to sharply raise our exposure to UK equities.
But the case for buying US equities is even more compelling. As at the close of business on Friday, the earnings yield ratio on the S&P500 fell to its lowest level since 1958 (see chart below). This could be a signal that the US economy is heading towards a major recession in which corporate earnings not only decline but fall precipitously. However, we doubt that this will be the way things turn out. Granted, corporate earnings will slow in the face of sustained sub-trend growth, but we continue to question the likelihood of an outright recession. And surely the chances of this have been further reduced by the Fed’s decision to cut rates. Providing that we are right in that the US (and therefore the global) economy is able to steer clear of recession, the falls in share prices that we have seen over the last few days will turn out to be a major buying opportunity.
John Clarke
GHC Capital Markets Limited