And now the recession – that equity markets are discounting

 
It is as if the banks are now operating in a vacuum - their modus operandi having been made redundant - and that because of this, and until a new operating model can be found, the market is unable to ascribe value to the players and their assets. It is hard to imagine a bank without any implied value but value is as much a function of the model that generates the earnings, as anything else, and absent the model, the market is unable to establish the worthiness of the banks. So it de-rates them.

Both the US and UK governments now have their own bailout schemes. For my pennies, the American version has much to commend it. For a start, the TARP (Troubled Assets Relief Program) is an attempt to introduce price discovery for unmarketable assets, something the UK version does not do.

However, all problem banks would probably benefit from price discovery. Also, by exchanging bad assets for good assets, the TARP might help improve the credit worthiness of the problem banks by improving the quality of their balance sheets. In doing this, The TARP then helps to lower default risk and hence current risk premiums in the credit markets.

By lowering risk premiums, the logjam throughout the financial system might begin to loosen thus opening up the transmission mechanism through which changes in monetary policy take effect. This would help to restore the recuperative powers of the economy and, in doing this, improve the prospects for a recovery from recession and diminish the risk of deflation. Wow, that’s a lot for 700 billion dollars!

Not since the crash of 1987 has the prospective p/e ratio for the FTSE 100 been as low as it is today (above chart). The current p/e ratio of just 8.5 is on earnings growth of over 8 percent for next year. Equities look inexpensive but, because of recession and the likely downgrading of earnings estimates, they aren’t quite as inexpensive as they look. But that doesn’t mean they do not offer good long term value.

Let’s allow for no earnings growth. This puts the forward p/e ratio for the FTSE 100 at around 9, which is what it averaged in 1988. A forecast for earnings growth of minus 10 percent for next year leaves the forward p/e ratio at 10, still undemanding on the view that the global economy is not going ex-growth. On a forecast of minus 20 percent, we would be talking about a p/e ratio of 11 but we would also be talking about much lower interest rates worldwide so, against that backdrop, a p/e ratio of 11 does not make equities look expensive, particularly if the efficacy of monetary policy is improving and enhancing the prospects for an economic recovery.

The above chart shows the high yield spread for the US corporate bond market. This is the yield on below investment grade debt minus the yield on investment grade debt. It also shows the year-on-year growth rate for US GDP (rhs). The inverse relationship between the two is clear; widening spreads have been associated with recessions.

As the chart shows, the spreads are back to where they were, or nearly so, during previous recessions. The message then is not just that the US economy has entered recession but that the corporate bond market could be discounting all or most of the bad news associated with recession. Furthermore, since the corporate bond market is influenced by factors that also influence the equity markets, you would have thought that, if the corporate bond market is discounting the forthcoming bad news, the equity market is doing so too.

Of course we don’t know what kind of recession lies ahead but we do know that sentiment is overwhelming negative. An example is the widely shared view that the rise in asset values and the good life which the borrowing binge sustained was all illusory and that the process of unwinding the binge will last for years. Allied with this view is the thought that retrenchment all round will bring with it a prolonged period of sub-trend growth and that the once buoyant returns in equity markets are well and truly over. And now the evidence of recession in the developed economies, which is accumulating, and the chart breakdowns with their series of lower highs and lower lows for the equity markets provide nothing but discouragement and feed the negative sentiment.

In a world of greed and fear and tops and bottoms in markets, I tend to associate greed with tops and fear with bottoms. When the financial system ceases to function, as it has, and savers become fearful about their deposits with the banks, we know there is plenty of … well, fear!

Writing in last weekend’s Financial Times (October 4/October 5 2008) Anthony Bolton expressed a sentiment probably shared by many portfolio managers. This was that the worst of it is likely to be in the market, according to his various gauges of market sentiment. As Mr Bolton put it, in the context of his own experience, ‘ … the heart of the stock market is sentiment flows, and when there are big excesses, you bet against them.’

I share the view. In one way or another, history repeats itself, meaning it is unlikely to be different this time. I think equity markets are in overreaction mode. They offer plenty of value for the long term investor. As you might imagine, they are very, very oversold and I would have thought we could be in for a snappy rebound shortly to a level they may be content to trade at until there is some clarity of vision.

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