Is there anywhere to hide?
Risky assets are under pressure across the board. When risk-seeking behaviour is replaced by risk aversion, all assets with a speculative component to expected total return are prone to poor performance.
The leading barometer of equity market prices in the world is the S&P500 Index. Though the Index price has fallen significantly since September, the Price Earnings (PE) ratio of this market has not changed very much. At the end of September last year, the PE ratio of the market was quoted at 18.4x. At that point in time, we heard analysts claim that this was pretty good value on the premise that the forward PE ratio was just 15x. This claim implies that earnings would grow at a 20% annualised rate; there was widespread complacency that earnings would continue to grow at a very healthy rate. By mid-January, the Index had fallen to 1380, 10% off of the September 2007 level, yet the PE ratio was still 17.8x. That is, the market had not become significantly cheaper on this measure despite the price decline. The explanation is that actual earnings fell 8% in Q4 2007, contrary to the consensus. Earnings forecasts are now being revised downwards. The market remains vulnerable.
US high-yield bonds are another risky asset class. The prices of these bonds are often expressed in terms of spread (extra yield) over US treasuries, which compensate investors for the risk of default. Credit spreads have widened sharply in the past nine months, from a low of 250 basis points (bp) in early 2007 to the current level of 600bp over US treasuries. By comparison, spreads reached a level of 750bp at the very widest levels of the last recession. By this measure, the market is discounting a high probability of a sharp economic slowdown in which corporate default rates would rise. The credit markets are now forecasting a reasonable probability that the economic slowdown will rival that of 2001-2002.
Another measure of appetite for risky assets is the performance of small-cap stocks relative to large-cap stocks; by comparing the Russell 2000 Index relative to the S&P500, small-cap stocks underperformed large-caps by 7% during 2007. This ratio had shown positive performance in every year from 2000 through 2006. Many equity managers (both long only and long/short) benefit from a rising trend in this ratio as they tend to find value in small- or mid-cap stocks whose growth prospects are not widely appreciated; some of these managers will hedge by shorting indices or large-cap stocks, which are fully valued and easy to borrow. For this reason, many of these same managers will have found the last few months to be quite challenging. We have seen a similar phenomenon outside of the US. In Japan and in Europe, small-caps have underperformed significantly over the past 12 months. By most valuation measures, small-cap stocks are not yet cheap relative to large-caps.
An asset class, which was the beneficiary of easy money over the past few years, was property. In the chase for extra returns, prices in some sectors of the global property market were bid up to unrealistic levels. In the United Kingdom, for example, prime office space changed hands at capitalisation rates (yields) of 4% or lower. Buyers at this level were paying very high prices relative to prospects for rental growth. The IPD Index of all property in the UK produced positive returns averaging 17% for the period 2003 through 2006. Over the past six months, prices have fallen by 9%. Amid the current environment of sharply deteriorating credit conditions, the correction probably has further to go.
What about bonds? Government bonds, led by US treasuries, have been a large beneficiary of the flight out of risky assets. Seen as a safe haven, the 10-year US bond yield fell from 4.70% to 4.02% during the course of 2007. The yield has fallen further to 3.70% by the middle of January. This flight to quality bid is likely to persist as long as the trend toward risk aversion is in place. However, bond valuations are looking stretched when compared to inflation. Real bond yields (the yield above inflation) have averaged about 3% over history. With US CPI all items showing +4.3% year on year, the real yield of the US 10-year bond is currently negative. This is unsustainable in the long run. The bond market has already discounted a series of Fed rate cuts. When the flight to quality momentum has run its course, bonds are in danger of entering an extended bear phase.
Is there anywhere to hide? In the short term, the direction of risky asset markets is very difficult to call. In the long run, they will recover. In the medium term, a focus on preservation of capital is appropriate. It is only when markets are viewed from a long only perspective that we should find the current trends depressing. Hedge fund managers who are able to capitalise on both up-trends and downtrends, and who are able to generate returns which are not dependent on market direction, are thriving in this environment. Good quality fund of funds are ideally placed to cope with the current market conditions.
