What do you do when all around you are panicking? If you are America’s Federal Reserve Bank, you panic too.
As markets around the world plummeted this week, the Fed suddenly cut interest rates. By three-quarters of a per cent. Before the market opened. And only eight days before it was supposed to hold the kind of official meeting where interest rates are usually cut. This is extraordinary stuff. Emergency cuts in US interest rates haven’t been made since 2001 (once on 3 January as the dotcom bust kicked in and once on 17 September just after September 11) and interest rates haven’t been cut by this much in one go for 26 years.
The move sort of worked. Instead of ending the trading day down 6%, as the futures market had suggested it would, the Dow ended down only 1.06%. The consensus in much of the City was summed up by an analyst talking to the BBC on Tuesday night. The cut, he said, was great news – not just because it had helped bail out the market, but because of the “message that went with it” (ie, that the Fed was going to step in at every possible turn to stop the market falling).
At MoneyWeek, we heard a different message. To us, the Fed cut means something more unpleasant: that Ben Bernanke and his committee know the US economy is in a truly shocking state; that the credit bubble is over; that the housing crash has barely begun; that recession is all but inevitable (and probably already with us); and, worst of all, that there isn’t much they can do about it.
The panic move, combined with the expectation that there will be yet another cut at the Fed’s meeting next week, doesn’t make us feel confident about the US economy or the markets. It simply confirms our suspicions that things are getting very nasty out there – you can re-read our thoughts on this here: Why the Fed’s panicky rate cut won’t save the US economy. The Fed says the risks to the US economy are “appreciable”. We reckon that’s a very polite way of putting it, given the stream of bad statistics coming out of the US. One example: 7% of Americans aren’t paying their mortgages at all.
The question now is exactly what investors should do about all this. Every few minutes a press release pings into my inbox explaining why this is a buying opportunity of some form or another. But now is not the time to pile into stocks. Sure, most markets are down hugely from their highs – the Dow is down 10% this year alone, the FTSE is off 13%, the Dax 19% and the Hang Seng 15%. And sure, on many conventional measures stocks look cheap. They trade on low p/es; appear to offer whopping great dividend yields (Royal Bank of Scotland looks like it yields 10%!); they’re cheap if you look at their earnings yields relative to bond yields (assuming you believe in this as a measure, which most don’t); and in the case of property firms they are on huge discounts to their net asset value (NAV).
But there is a huge problem here: all valuation methods rest on assumptions. Take a p/e ratio – the market price of a share divided by earnings per share (EPS). There are two numbers you can use for the ‘e’ bit. You can use last year’s profit number. This has the advantage of being a real number, but as the past is rarely a perfect indication of the future, it isn’t much good. If a firm has a low historical p/e ratio, all you know is that its shares would be cheap if it made the same profits it did last year. What you don’t know is if it will make those same profits.
That’s why most analysts use the forward p/e instead (ie, the ‘e’ is not last year’s profits, but this year’s forecast profits). The flaw here is obvious: no one has the faintest idea what this year’s profits for most firms might be. If they are lower than forecast, the markets won’t look so cheap after all. And, be in no doubt, they will be lower than forecast.
The Fed’s rate cut might have stopped the stockmarket crash in its tracks, but we can’t really see how it can do the same for recession. With lenders tightening standards across the board, lower rates can’t help subprime borrowers; they can’t do much about credit-card defaults; they can’t help firms that are already struggling. And, crucially, they can’t make people with no appetite left for debt borrow money, nor make worried company directors facing falling sales and tighter credit conditions stick to last year’s expansion plans.
The key determinant of credit growth, points out Gabriel Stein of Lombard Street Research, is not interest rates but credit demand. And despite the fall off in interest rates in the US over the last six months, growth in that has not been rising, but falling. Add it all up and it seems that profits have to fall, maybe 20%, maybe 30%, and maybe even more, given that they are currently at historically high levels. All we can say almost for certain is that they will fall enough to make it clear that today’s equity prices do not represent value.
Much the same is true of dividend yield numbers. Right now DSG International (DSGI), owner of Dixons, looks like it yields 14%. But it will only do so if it pays out the same dividend this year as it did last year. Will it? In the middle of a consumer recession and just as house prices are falling? Doesn’t seem likely. The same goes for the banks. They’re all offering storming-looking yields, but there’s no guarantee that anyone who buys in now will end up with anything remotely resembling the payout last year’s shareholders got.
No one appears to have done the numbers for the UK banks yet (will it ever be clear what exactly analysts are paid for?). But in the US, Credit Suisse has looked at the options market and found it implies that 17 of the financial stocks in the S&P 500, including Bear Stearns, Countrywide, Merrill Lynch and Morgan Stanley, will cut their dividend by mid-year and that the yield for the group is likely to fall by 38%.
The options market “isn’t exactly foolproof” as a predictor, says Dwight Cass on Breakingviews, but it “has historically been more right than wrong”. Note that Merrill Lynch has raised its estimates of its subprime losses from $5bn to $8bn and then to $15bn over the last six months alone. Why wouldn’t it cut its dividend if it needs to preserve capital? It isn’t as if it has a reputation to protect any more. There will be individual bargains out there – in the UK, Lloyds might be one, and we’ll be watching for good deals in the pharma and infrastructure sectors (power, water and the like) – but do not make the mistake of thinking the market as a whole is cheap. It isn’t.
So what of oil and metals and mining? Surely there must be bargains there? We wonder. We’ve written a few times this year about our newly cautious approach to hard commodities and I don’t think now is the time to change our tune. I’ve no doubt the supercycle in commodity prices is intact – all the long-term factors that have created the tight supply/demand situation are still with us. But it’s also likely to take something of a breather this year. The London metal index has already fallen by more than a fifth from its highs, with some individual prices (eg, nickel) falling far more.
The only thing that could keep metals utterly unaffected by US recession would be proof that the Asian economies can decouple from the US – continuing to grow at the same speed as they would have were America not headed for recession. We’re not going to get that proof: the last few weeks have made it clear, as we’ve been saying for months, that the decoupling theory represents less a rational reality than stockbrokers’ collective wishful thinking.
And what of oil? We are still convinced by the peak oil theory (that the supply of cheap oil is severely constrained) and we remain certain that demand will keep rising over the medium term. But again, we’ve been urging caution on this in 2008 and we still think this is no time to buy more.
Recession in the US will cut demand for oil not just in America, but everywhere as factories manufacturing goods for once-frantic US markets pull back, cutting their energy usage as they do so, and as the managers of those factories put off buying their first car for a year or so. Long term, the oil price has to keep rising – demand in India and China is expected to double in the next decade and there hasn’t been a major new oil field discovered in 40 years – but that doesn’t mean it won’t fall this year. One for your pension fund, not your trading account.
So what else can you buy? We like precious metals and you might look at soft commodities – the boom there probably has further to run. See below for more. But when it comes to individual markets, we love Japan. It has fallen 18% already this year, but to be honest the further it falls the more we want it. Why? Because it is ridiculously cheap. More than half of the market is trading below its book value (the “best single measure” for determining value in Japan, says KBC’s Jonathan Allum) and a large proportion of it is even cheaper than that. Indeed, you can buy the shares for less than the cash on the balance sheet, making them better than free.
I can’t tell you when the market will turn – it’s so loathed at this point, it could take years – but as one of my old clients from my days as a Japanese stockbroker in Tokyo told me last week, “buy Japan, put it in your pension, and (assuming you are under 50 now), you’ll have a good retirement”.
Why you should stock up on food
Last week I spoke to three investors who MoneyWeek rates very highly: hedge fund manager Hugh Hendry, investing veteran Jim Slater and commodities guru Jim Rogers. They all told me the same thing: the best place for your money right now is in agriculture. Why? Four reasons, says Slater.
First, the world population is on the up so the demand for food in general is rising. Second, there has been a huge rise in the affluence levels of the southeast Asian population in the last decade, which has bumped up demand for proteins in particular. Already, 70% of the world’s grain harvest is used as animal feed and that, says Slater, is a number that can only rise as the Chinese and Indians eat more meat: note that it takes two kilos of grain to raise one kilo of chicken and a huge eight kilos of grain to raise one kilo of beef.
Thirdly, grain stocks around the world are already at 50-year lows. In China in particular, where both water and land are scarce (environmental degradation is destroying farmland and water pollution is a huge problem), inventories of agricultural products are “dangerously low”, says Ritesh Menon of Singapore’s DBS Bank. Note too that arable land per capita in China and India is only 18% and 26% of US levels respectively.
Fourth, huge amounts of land once designated for food crops have been diverted into the biofuels business in response to America’s misguided but seemingly unstoppable policy to make 20% of their energy usage biofuel based by 2022. Finally, there is climate change: changing weather patterns – from droughts to floods – have been hitting harvests and will probably continue to do so. So supply is low and demand is high – that’s a recipe that usually drives prices higher.
What’s more, right now prices of many agricultural commodities are, despite the boom of the last few years, trading at very low prices relative to history: sugar is 85% below its all-time high in real terms, says Rogers, while coffee and sugar are still off 70% and 50%.
So how do you buy into this fabulous sounding story? We’ve long been suggesting the very simple route of buying the ETFS Grains (AIGG), which tracks the prices of a basket of grains, but it should come as no surprise that Slater and Hendry have rather more innovative approaches. There are obvious ways to get into agriculture via the stockmarket by buying shares in the likes of Deere and Monsanto, but these are hardly uncrowded trades: both are already expensive.
However, by “digging deeper” Hendry has unearthed a list of 400 other agricultural stocks, many of which are both unfamiliar and illiquid, but which also offer really “compelling valuations”. Think Ukraine-based and Warsaw-listed agricultural holding company Astarta (AST PW), US grain handling business ADM (ADM), or one we’ve mentioned before, Norwegian plough manufacturer Kverneland (KVE NO).
Slater’s approach is different: he is focusing his agricultural investments in Brazil. Why Brazil? Because it has the best water table there is (15% of the world’s fresh water); because it has “masses of prime agricultural land” and is already the world’s leading exporter of beef, chicken, coffee and sugar; because Brazil’s sugar cane makes better biofuel than America’s corn.
And finally, because, agriculture aside, it has a pretty good economy. Brazil comes with a growing middle class, a popular leader, a strong currency, good trade surplus and vast mineral wealth. Jim Slater likes it so much that not only is he buying up land, but he’s already put £2m of his own money into the iShares MSCI Brazil (NYSE:EWZ) exchange traded fund.
All this sounds great, and I think I buy into the story almost as much as these three do – my own pension is stuffed with AIGG. But one word of caution. Mark Twain is famous for pointing out that we should all buy land because “they don’t make it any more.” But while it is clearly the case that you can’t make land, you can make farmland. You can bring marginal land back into use; you can cut down rainforests and plant them with palm oil (I’m not advocating this by the way, just saying it happens); and you can dig up your sweet peas and plant potatoes instead if the economics suggest you should.
So if prices really soar, we might suddenly see that supply is not as constrained as it looks: note that part of Jim Slater’s plan is to buy up marginal land and irrigate it to bump up yields. With that in mind, cheap tractor stocks may be a better buy than grain ETFs.
Rise of China has barely begun
If anyone’s been a bull on China over the last few years, it has been Jim Rogers: he’s packed up and moved his family to Asia, he’s insisted that his tiny daughter (who has been given the expectations-laden name of Happy) learn to speak Mandarin; and he has been pouring money into China and writing books about it at every turn. So, on the phone to Singapore last week, I asked him if he would really suggest buying China now.
He would. He expects the economy to slow. How can it not, given interest rates have already risen six times and that it has no way of hiding from global slowdown? But he sees that not as a problem, but as “an opportunity for those with the vision to buy in”.
Look at what happened on America’s path to prosperity, says Jim. “There were 15 depressions in the 19th century, there was corruption, a total disregard for human rights and the occasional massacre on the streets.“ You’ll get the same in China along the way, but, as with the US market over the long term, stick with it and you’ll make money.
But isn’t the market nearing bubble territory? Apparently not. Look at the market over the last seven years and you’ll see it has barely budged: it may have soared in the last two years, but it fell for four before that. Today the Shanghai SE Composite Index is trading at around 4,700. If it was 9,000, says Jim, that would be “a bad place to buy”. But this is a “good place to buy” and if it falls to near 4,000, “buy, buy, buy.”