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There's more to volatility than angst!
By Mike Lenhoff 20/02/2007 00:00
Volatility creates angst. It stirs up talk about the re-pricing of risk. The VIX gets lots of attention and there’s plenty of reference to the quality spreads at the less liquid end of the corporate bond markets.
• There is talk about indebtedness at all levels. The fear that volatility might set in motion a de-leveraging avalanche reflects itself in the widening risk premiums in the markets for credit derivatives. Concern grows that this will compound the volatility.
• Pointing out that risk premiums have widened is fine but it can be a bit like saying there’s heat in the kitchen when the stove has caught fire. Not much help for the cook unless, of course, he’s out of the kitchen, and then what matters is when to return.
• Volatility creates opportunities. For those swept away by a rising tide, in this case equity markets which have performed stongly, it encourages a re-think of the relevant fundamentals. For investors with a long term commitment to equity markets, the volatility offers a buying opportunity. It did so last summer and we reckon it is doing so again, though we doubt that this bout of volatility has run its course.
• In a recent note (see It’s Been Payback Time! 6th March 2007), we indicated what saw as the potential downside for the FTSE 100. This was a 10 percent correction from top to bottom, thus taking the index of leading blue chips as low as 5800 and putting the FTSE 100 on a 12-month forward p/e ratio of around 11.3 times, even less than what it sold for after last summer’s correction. For the S&P 500, a 10 percent correction from top to bottom would take it to around 1325, which is just below its present 200-day moving average. This would put the S&P 500 on a 12-month forward p/e ratio of close 13 times, also less than what it sold for after last summer’s correction.
• We have taken the view that the global economy is on a solid footing. However, we know that earnings growth is set to slow this year. That need not be a big deal, especially after a long stretch of rapid and unsustainable double digit growth. The trouble is that earnings tend to be overestimated during a slowdown. They end up disappointing and are often downgraded, thus making prospective p/e ratios not quite what they seem.
• Here then is some good news. Consensus estimates for earnings growth in 2007 have been revised downward - and sharply in the case of the US. For example, earnings for this year are now expected to grow by 6.6 percent. This past October the figure was 9.6 percent. At the start of this year it was 8.2 percent. In the UK, the trend has been similar. Earnings for 2007 are expected to grow by 6.8 percent. Last October the consensus reckoned on 7.5 percent. By the start of the year, the number had been shaved to 7.3 percent.
• These downgrades diminish the prospect of there being significant earnings disappointments ahead. Even if the estimates are trimmed a little more, a 10 percent correction still leaves the equity markets attractively valued.
• Rising interest rates are the other concern we have had. In the UK, the eurozone and Japan, it is just a matter of time before the central banks put rates up again. In the US, the Fed is on hold but a tightening bias remains. However, if developments in the sub prime mortgage market spill over to the prime market or adversely affect consumer spending and/or curtail lending, thus increasing the risk of a recession, the Fed is in a good position to cut rates aggressively.
• We have no reason for thinking that the sell-off in equity markets is anything more than a correction. As indicated in It’s Been payback Time, equity markets need a sturdy base to sustain a rebound. Developing that base can take time, as it did last summer after the sell-off in May. A period of backing and filling is likely, meaning that equity markets will have their good and bad days but, like last summer, we reckon the volatility presents a buying opportunity.
* The information contained in this report has been taken from public sources and is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. The opinions expressed in this document are not necessarily the views held throughout Brewin Dolphin Securities Ltd. No Director, representative or employee of Brewin Dolphin Securities Ltd. accepts liability for any direct or consequential loss arising from the use of this document or its contents. We or a connected person may have positions in or options on the securities mentioned herein or may buy, sell or offer to make a purchases or sale of such securities from time to time. In addition we reserve the right to act as a principal or as agent with regard to the sale or purchase of any security mentioned in this document. Prices, values or income may fall against the investor’s interests. You should therefore be aware that you may get less back than you invested. Past performance is not necessarily a guide to future performance. If you are in any doubt concerning the suitability of these investments for your portfolio, you should seek the advice of a qualified investment adviser.
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