Anyone who saw ex-hedge-fund manager and stock pundit Jim Cramer lose it on CNBC’s Mad Money show last week will know that panic now stalks Wall Street. Cramer kept screaming that the Federal Reserve had “no idea how bad it is out there” and that chairman Ben Bernanke should “open the liquidity window” and cut interest rates. Indeed, futures are suddenly forecasting a US rate cut before the year is out. And more petrol was flung on the flames by Samuel Molinaro, chief financial officer of battered US investment bank Bear Stearns, who said that in 20 years he had never seen the credit markets looking so bad.
This sort of hyperbole has sent sentiment nose-diving. Bernanke has already made it clear he won’t bail out financial market liquidity crises as his predecessor did (the famous ‘Greenspan put’), which is scaring shareholders even more. For global equity investors, the credit market is an unfamiliarly occult sphere at the best of times. They see panic in credit markets, and uncertain what it means for stockmarkets, they’re selling now and asking questions later – if at all.
I have previously warned that the US housing market would only get worse and that subprime mortgage woes would indeed spill out into wider credit markets. So you might think I’d be the last person to call for some perspective right now. But you’d be wrong. What I feared was that none of this deteriorating credit picture was in the price. Stockmarkets had been rising inexorably all year, oblivious to the credit storm clouds. The situation is indeed made worse by the fact that most of the affected investments (known as collateralised debt obligations, or CDOs) are backed by unquantified, but significant, amounts of subprime mortgage-backed securities (MBSs); and it doesn’t help that they are also so illiquid that there isn’t even a market price. This is why the two Bear Stearns hedge funds that have blown up are doubtless the tip of the iceberg.
But although we can’t see clearly into this Pandora’s box, it has now been opened and fear, made more palpable by uncertainty, has been let out. The era of overly cheap debt for poor credit risk is undoubtedly over. So what’s changed and what does it mean for future asset-price movements? Well, remember that equities are at risk when the bond yield, relative to the equity earnings yield (the inverse of the p/e), goes too high – more on this in a moment. If government bonds yield more than equities, as in the dotcom bubble, or in 1987, then a complacent equity market is indeed vulnerable to a crash.
Now, all this fear means equity markets are hardly complacent, but surely credit-market woes mean rising bond yields, and that can’t be good, right? Well, seemingly unnoticed, government bond markets have rallied sharply as credit fears at the risky end of the spectrum have seen a flight to quality. Government bond yields across the globe are now down to where they were before this whole subprime/inflation scare story blew up a few months ago. Ten-year gilts now yield less than 5.2%, having been up at nearly 5.6% just a month or so ago. So what we need to ask is this: are equities expensive or cheap compared to government bonds? To decide, we need some way of comparing the bond yield to the return we can expect from equities. As mentioned above, the simplest way to do this is via the basic p/e valuation measure (essentially the number of years it takes to earn your money back). The inverse of the p/e, calculated by taking one over the p/e, is the “yield” the firm’s earnings give you. It doesn’t matter whether the firm pays this “yield” out fully or not, because any money it doesn’t pay out will be reinvested for a better return than the market rate.
The FTSE 100 is on a forecast p/e this year of about 11.8 times, so the earnings yield you get from buying the index is a whopping 8.5%. This is pretty much the highest yield available from blue-chip equities for more than 15 years. Our major blue chips are giant cash-generating machines, producing two-thirds more profit than in the late 1990s. Yet they can be bought at about the same price as back then. Put like this, the earnings-yield argument implies equities have the scope to outperform gilts by over 60% in the medium term. How did they get so cheap?
Well, in the near term, it was the panic in the credit markets and the uncertainty it engendered. That alone pushed the FTSE 100 back down over the last month to April 2006 prices. On a longer time frame, the FTSE 100 has gone nowhere for nine years. Well, that’s not exactly true. We had the dotcom bubble (though few of today’s FTSE 100 stocks were really involved in the excesses of that time), then the post-bubble sell-off and after that the slow, steady climb back to pre-bubble levels. Commentators still worry that now we’re back near bubble peaks, we must be vulnerable again. And they’d be absolutely right.
Or rather, they’d be absolutely right if nothing else had changed. But plenty has changed. If share prices are now back at 1998 levels, but the profits backing those prices have nearly doubled, then that means valuations have halved. It is a well-known saying that bull markets climb a wall of worry – and what a load of worry warts we have been all the way up since those 2003 lows. We’ve worried about the speed of the climb, the distance the market has moved and the lack of a really big correction on the way. We’ve worried about deflation, inflation, higher bond yields and now a crisis in the esoteric world of credit spreads. What has all this worry done? It has held the FTSE 100 pretty much flat for nearly a decade of economic boom, easy credit, ballooning profits and soaring property prices.
We should ask ourselves, what would be the ideal scenario to invest in for the expectation of well-above-average returns? The wish list is long. Our chosen asset class would need to be outstandingly cheap on a long-term historical basis, especially compared to government bonds, the sole arbiter of financial market relative value. The FTSE 100 is. We would like to see evidence that medium-term fund flows were ready to pull out of the overvalued assets that had previously been the markets’ favourites. Finally, we’d look for fear, especially fear of something that wasn’t really relevant, to knock prices of our already undervalued asset class to the bottom of its recent trading range, so we could buy on a dip and boost our near-term performance too. Too much to ask at any normal time – but a fair description of what we see today.
Importantly, we are not seeing a collapse in bond markets, far from it. Government bond markets as they pertain to big blue-chip stocks like those found in the FTSE 100 are rallying and remain at around the same benignly low yields they’ve been at for half a decade. Rather, we’re facing a repricing of risk (and to be fair, quite a mild one so far, by historical standards). The situation here is the beginning, and not before time, of a rational widening of credit spreads back towards some sort of norm. Hence what is at risk here are asset classes that have relied on access to stupidly cheap debt: private equity and their cheap ‘cov-lite’ (ie, ‘very high risk’) debt; property, both commercial and residential, where implied rental returns are dangerously low compared even to today’s cost of debt; and all types of junk debt (also known as high-yield bonds, but where the “high” yield has recently been as low as it ever has been compared to risk-free government bond yields – see lefthand chart on facing page). The winners in such a scenario should be low-risk, high-return assets, and we’re lucky in this respect because one asset class stands out here. London commercial property now yields less than 4% (no more than the FTSE 100 dividend yield). Junk bonds and emerging-market debt yields only 200-300 basis points more than the risk-free rate (in just the last decade, spreads have been as high as 1,000-1,100 basis points). UK government bonds yield just over 5%. Against this backdrop, blue-chip FTSE 100 stocks have an almost staggering earnings yield of 8.5%. It’s literally unprecedented.
On top of this, as the chart on the left shows, the FTSE 100 has hit its 300-day moving average (purple line), while also dropping below two standard deviations from trend. That may sound a bit technical; the main point is that this is a strong buy signal which we’ve only seen three times before in this bull market (see the green circles). But be choosy about the equities you buy. The next stage will be all about rotation into high-quality, relatively low-risk stocks. Even mid-sized FTSE 250 stocks aren’t great value, having been driven up by overly cheap debt, and the belief that they were not too big to be targets for debt-financed private-equity deals.
For the last three years the FTSE 250 has outperformed the FTSE 100 massively (see right-hand chart on facing page) and that needs to mean revert (see page 36 for an explanation). FTSE 250 stocks historically carried an approximate 25% p/e discount to their larger, more diversified and less risky blue-chip peers. Today they are at a near-25% premium. The value is very much concentrated at the top end and that is where the canny investor should go. You could do a lot worse than a cheap FTSE 100 tracker. But investment trusts that have a track record of buying such stocks, but which trade at a substantial discount to net asset value, such as Alliance Trust (ATST) (where the discount is just under 17%) offer another very exciting way in. The timing may yet prove tricky, but the James Ferguson pension fund came out of bonds earlier this week and went 100% into high-yield, blue-chip UK equities.
James Ferguson also runs his own share-tipping service, Model Investor