Skittish, not sick

The JSE is currently enjoying its fifth year of positive returns. From a low of 7360 in April 2003 to the recent peak of 29500, the market provided a massive total return of 318%.

Obviously, part of this was a necessary rerating from particularly oversold levels. The main driver was the economy: we basked in the glow of the longest growth period since WWII, which was fuelled by the strongest commodity bull run in 30 years and resulted in a record expansion of the SA economy and new record levels on the JSE. Despite all of this, the forward PE on the JSE is roughly 12 times. 

Many investors are nervous, having lost substantial amounts by being over-exposed to the small company and technology stocks during the stormy exuberance of those sectors during the late nineties and early 2000s. The current situation is entirely different to then, simply in terms of value, and the big difference this time is earnings. Both small companies and technology stocks were trading on PE multiples in excess of 60 and sometimes even in excess of 100, with little or no earnings and a promise of future earnings that seldom materialised.

The world today is in reasonably good shape; economies are growing (the IMF recently upgraded its forecast for global economic growth for 2007 from 5% to 5.3%); markets are reasonably priced; there is abundant cheap capital; and where the US consumer slows, the Asian consumers should fill the gap.

So what, therefore, is happening at the moment?
 
The early 2000s saw America unwinding the excesses of the nineties. Corporate greed, corporate fraud, tax evasion and accounting irregularities were all almost accepted business practice in the hedonistic pursuit of earnings, all of which led to overpriced markets, not to mention some of the most spectacular corporate scandals, collapses and arrests that the world had seen.

Disillusioned by equities, the next 'game' was property, and US investors poured every cent they had into residential property. This is not dissimilar to the rest of the world, but the way that the Americans lend money is. Lured by cheap loans (at least initially), investors literally 'bit off more than they could chew', and for those near the bottom of the economic ladder (the sub-primers), nausea and vomiting ensued. South Africans spend roughly 74% of our after tax income on servicing debt. Both Britain and the US spend over 100%, with the US closer to 130%, i.e. they are living on debt and relying on asset prices rising.

Our recently enacted National Credit Act will go a long way to protecting against reckless lending (and borrowing), which should protect us from a sub-prime type meltdown as is currently underway in the US. This is having a knock-on effect, as companies find it harder to raise money and have to pay more for borrowed money as the world re-evaluates risk.

What is the outlook for SA?

It is important to recognise that this is a US problem. Once again, US excesses are unwinding and are going to have to work their way through the system. The fact that it is a US problem does not mean that we wont be affected. We will be affected by the re-evaluation of risk, which will affect emerging markets and economies, so expect a bumpy road ahead.

However, markets are reasonably priced; the world (and SA) economies are delivering solid earnings and there is abundant cheap capital, which will be looking for opportunities (not to mention that Mr Bernanke has a lot of ammunition in his interest rate gun, which could instantly provide relief if the turbulence became dangerous). Expect a correction, not a collapse. Barring a complete credit meltdown (which is highly unlikely), this shouldnt last long, but it is probably advisable to keep your seatbelts fastened, as there will be more turbulence to come.

So what are the key messages?

1) Equities are reasonably priced, so there is no need to try and time the market by selling out and then trying to get back in. The Investec Value fund, for example, is on a PE of 11 and a dividend yield of 4%. If you are looking for an opportunity to invest, its getting close. If in doubt, phase it in over two or three instalments, a couple of weeks apart.

2) If you have a conservative risk profile, now is the ideal time for a managed/balanced fund such as the Investec Managed and Investec Opportunity Fund, where a professional decides how much equities, bonds, property and cash to hold. For more conservative investors, low equity versions exist where fund managers are restricted to certain limits, i.e. a maximum of 40% equities such as the Investec Cautious Managed Fund.

3) If the SA market or the Rand worries you, now is not a bad time to diversify offshore. Once again, a balanced fund such as the Investec Global Balanced Feeder Fund is an option, allowing a professional to decide not only on your asset allocation, but also on your geographical allocation  (how much US, Europe or the East) and your currency allocation (how much US$, Sterling, Euro, Yen etc). 

Markets go through periods of accumulating and unwinding excesses. This is exactly what is happening now. Markets are skittish now rather than sick or scared. Turbulence is expected, but you should still continue perfectly safely. 

By Jeremy Gardiner, director, Investec Asset Management