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Will the equity market rally extend beyond the second quarter?

17 July 2009 Gareth Stokes
Gareth Stokes, FAnews Online Editor

Gareth Stokes, FAnews Online Editor

Global equities have staged a remarkable comeback in the second quarter of 2009. The Morgan Stanley World Index (dollar based) clawed back 40.0% from its March 2009 lows and produced the best quarterly performance since 1998. The rapid rise in equities ca

On Wednesday, 15 July 2009, FAnews Online attended Investec Asset Management’s Q2 2009 media briefing to find out if another market correction is imminent. We turned to Investec SA head of equities, Sam Houlie, for an answer. While he couldn’t rule out the possibility that recent price movements deserved the ‘bear market rally’ tag, Houlie provided plenty of statistical information to suggest fears of a correction are misplaced. We’ll discuss three of his observations in more detail below.

Don’t bank on another correction

His first observation is that “bear markets bottom well before recessions end.” In other words, equities come on the boil long before the real economy shakes off the last vestiges of recession. This holds true for each of the nine recessions recorded since World War II. If we consider the US economy satisfied the technical recession definition as early as December 2007, then a market bottom in March 2009 should tie in with an economic recession that still has six to 18 months to run.

Houlie’s second observation centres on inflation. “Equities rally when the market perception moves from deflation to inflation,” he said. In December 2008 – and the first two months of this year – international investors were obsessed with the threat of deflation. This obsession shows clearly as a sharp downward spike on the graph of US 10 Year ‘Expected Inflation.’ Severe deflation is unwelcome because it stunts economic growth. So the minute US perceptions changed from deflationary to inflationary, equities were released. And they should remain robust as the inflation outlook improves further.

And the third observation goes to the amount of cash parked in low-yielding money market accounts. Many investors in the US and other developed economies are sitting on cash that is earning close to 0%. Dudack Research Group produces a graph to illustrate this phenomenon. They record the total money market funds as a percentage of US market capital over time. At the beginning of 2009 this measure topped 34%, before declining to around 28% by mid-year. The mean going back to 1979 is closer to 12%! “This money will find its way into equities,” said Houlie. And provided there’s a surplus of yield-seeking cash looking for an entry point to the market we can expect share prices to remain resilient.

Earnings shock looms in resources sector

South African equities have followed US equities higher. A snapshot of sector performances over the last 12 months shows pharmaceuticals (+68%), food & drug retailers (+36%) and food producers (+29%) on the top of the pile, with automobile parts (-57%), industrial metals (-55%) and forestry and paper (-54%) on the other end of the scale. If we zoom down into major sectors then the real underperformer was resources. The sector, which makes up a significant part of the JSE All Share, fell 44% in the year beginning 1 July 2008. “Last year, this time, there were very few who would have opted out of resources,” said Houlie. Diversified resources share Anglo American was typical of companies in the sector. It changed hands at more than R550/share as commodity bulls stuck to their guns!

“Resources have massive downside risk on earnings,” said Houlie. This is largely due to volatility in commodity prices and sharp differences in the values achieved by mining houses for their production. Mining companies are also battling a margin (and profit) squeeze due to a basket of factors, including rising electricity charges, wage settlements and the strong rand. “We think that earnings could surprise on the downside,” said Houlie, singling out platinum miners as trading in territory far too high for the potential downside risk to their earnings. Houlie excluded miners from his portfolio last year because commodity prices were “crazy” and speculation dominated the sector. He felt the levels weren’t sustainable. Today the reason for excluding the sector is slightly different. Houlie is concerned that earnings expectations are too high.

Over the next 12 to 18 months ‘stock picking’ will prevail over ‘sector bets.’ “Any sector bet that portfolio managers have will be a result of picking stocks rather than a macro-economic overlay,” said Houlie. Although stocks aren’t as cheap as they were, you can still build a portfolio of reasonably priced companies.

Tail winds in the banking sector

There are a number of economic tailwinds that should lift specific shares in the banking sector in coming months. Houlie says bad debt provisions – particularly in the retail space – are at historic highs. Apart from the risk of corporate default the situation is unlikely to compound further, meaning banks earnings will normalise as the bad debt provisions wind down. A further argument for South African listed banks is that their price-to-earnings ratings lag emerging sector peers by quite some margin. These ratios have improved by 400% in Russia and close to 100% in Hungary, Israel and Korea. “There are no fundamental reasons for our banks to be trading at this discount,” said Houlie. Local banks will record depressed rather than negative earnings growth in coming periods. But “there is a massive tailwind for earnings in the sector.” Houlie’s views reflect in the top 10 equity holdings across the Investec portfolios he manages, with Standard Bank (9%), African Bank (9%), Old Mutual (8%) and First Rand (6.4%) in the top six.

Investec said that South African investors have plenty of opportunities to purchase quality stocks at historic lows. Over the next year the groups’ focus “will shift from sector divergence to the broad-based undervaluation of the market.” In summary, Houlie noted that Investec “was bullish on valuations, didn’t believe a correction was imminent, and thought a disciplined approach focussing on valuations would work over the long-term!”

Editor’s thoughts:
Many investors missed the first leg of the global equity recovery as they sheltered in ‘safe’ cash investments. Now they’re getting ready to pour that cash into an overheated market… Do you think there will be another market correction, or do you agree that shares will trade higher over the next year? Add your comments below, or send them to

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