Marriott road show July 2009 – the international view

Equity markets have seen their worst performance in 70 years

In recent months, international equities markets have witnessed one of their worst levels of performance over the last 100 years. In fact, we would have to go back to the Great Depression of 1929 to see such poor short term returns. In local currency terms, the FTSE 100 fell by nearly 50% between June 2007 and March 2009 whilst the Dow Jones Industrial Average declined by 53% between October 2007 and March 2009. On a ten-year basis, the situation is no better, with markets still trailing the levels they were at in July 1999.

The main cause of the market backdrop has been the global credit crisis which was arguably triggered by the 1999 repeal of the Glass-Steagall Act. Promulgated in 1933, the Act was introduced in the US in the wake of the 1929 stock market crash and sought to separate investment and commercial banking activities: the aggressive behaviour of financial institutions was widely seen as the main cause of the financial meltdown at the time.

But the 1999 repeal opened the door to a return to high-margin, high-risk activities on the part of the banking institutions and this seems to be a case of history repeating itself.

A recovery is on the horizon

In the recent cycle, the low point in sentiment was reached in September 2008, when Lehman Bros collapsed, but it is not certain that a full recovery is under way yet. For example US company CIT Group, amongst others, is currently threatening to file for bankruptcy, which may threaten the nascent recovery.

There are, however, are signs of ‘green shoots’ in developed world economies is on the horizon. Improving Purchasing Managers’ Indices, consumer confidence data and a slowdown in the rate of decline in the housing market all suggest that GDP growth will resume in 2010 in major international markets.

At Marriott, we are anticipating a return to positive growth in the US economy in the fourth quarter of this year, but we believe that it will be muted growth at best. Overall, the US economy will probably fall by 3% in 2009 with a mild recovery to 1% in 2010, a scenario which will be replicated in Japan and the UK and, eventually, in Europe.

On the inflation front, the big debate rages around deflation and to what extent that could take hold in the developed world. Of course, deflation is a highly undesirable phenomenon as it dissuades people from buying. In the US, where the economy is based on consumer spending, the effects of deflation could be disastrous.

In addition to the general fall out from the credit crisis, one of the reasons for the decline in inflation rates over the past year has been the dramatic slump in commodity prices from their 2008 peaks. A striking example of this is the oil price, which lost some 75% of its value in the second half of 2008. Central governments are tackling this issue with a combination of low interest rates and so-call Quantitative Easing in an attempt to pump prime the economy. Marriott believes that over the next few months, these measures together with a slowly improving economic backdrop will be sufficient to prevent a deflationary spiral which proved so disastrous for the Japanese economy in the 1990s.

It is easy to buy at the top

It is easy to buy at the top of the market. An interesting (and by no means unique) example comes from analyst forecasts made in March 2000. Ten top analysts, uniformly called Vitesse Semiconductor Corp as a buy or strong buy. That turned out to be the peak of the tech bubble. Quite clearly, analysts also get caught up with the emotion of the moment. One needs to adopt a more sober approach to investing and that may mean taking a contrarian view.

One metric that can be used to assess the extent to which a market is offering value is Tobin's "Q" ratio. This measures the replacement cost of the net assets of a company relative to its value on the stock market. If the ratio is greater than 1, it implies that the market is overvalued and at less than 1, the market is undervalued. Significantly, the Q ratio picked up each of the major bubbles over the past century. With the Q ratio for US equities not only below 1 but also currently below its long term average of 0.74x, this adds a measure of comfort to investing at present.

A second measurement which we use to study value is the Shiller real PE ratio which uses a 10 year moving average of earnings rather than a single year’s data. Barclays Capital have taken this a stage further and combined Tobin’s Q ratio with the Fuller PE sample to show that US equities offer significant value on a 10 year basis following the recent market falls.

So what should an investor do now?

There is considerable debate as to whether we are at the start of a significant market recovery or whether we are simply approaching the centre of a ‘W’ shaped recovery with a further pull back likely in the near future. Either way markets are considerably less expensive than was the case 18 months ago and Marriott believe that we are closer to the bottom than the top of the market. As uncertainly is removed, so markets will move higher in anticipation of a recovery and Marriott suggests that investors who have not already done so should consider starting to invest now whilst markets and many individual securities still offer good value.

The Real Estate sector has suffered more than the wider market because of the high level of gearing in the market. In addition, the shortage of credit has caused considerable pain for those businesses unable to raise capital in other ways. At its most extreme level, this led to the collapse of General Growth Properties in the US, a former stock market bellwether.

With the market now at pre 2001 levels, Marriott are once again looking to encourage clients to take a closer look at international real estate. Having called the top of the market in 2006/7, clients are now being advised to start to invest at depressed levels partly to lock in a solid gross dividend yield of around 6% but also to capture the potential for capital gains as the economy recovers. A number of metrics support this case for investing. Stock prices which traded at a substantial premium to net asset values at the peak of the market are now at big discounts and the yield premium of the real estate investment trust sector in the US has widened significantly against the benchmark 10 year US Treasury. These metrics can get worse, of course, before they get better but on a 3-5 year view, the sector offers good value.

We have started to nibble at real estate and have recently taken a 5% property exposure in the Marriott International Growth Fund.