I was wondering last week if the Icelandic volcano eruption might have an effect on stock markets. Not because it would actually affect revenues, profits or valuations but just because it might be the kind of thing that would push the investing population out of “all news is good news” mode and into “all news is bad news” mode.
I said as much in the blog last week. The response was pretty brutal. “Oh, cheer up,” said one reader, before going on to accuse me of taking bad news – from swine flu to the implosion of Greece – far too seriously and of being utterly incapable of seeing the good in anything.
Even so, this most recent bear market rally (or bull market – I’m never quite sure when one becomes the other) has now been running for long enough that it is surely worth revisiting the many risks it faces.
Clearly, the market doesn’t think that the costs of the disruption to travel caused by Eyjafjallajökull – which could be anywhere from $1bn to $10bn depending on whom you listen to – are that big a deal. But what of the fact that the Office for National Statistics has just released the worst employment numbers for 16 years in the UK? Or the inflation numbers released last Tuesday show that the consumer price index is now running at not far off double the Bank of England’s target rate of 2%? They might turn out to be more of an issue.
Anyone who thinks that the financial crisis is over might also look to the housing market in the US. This is where the nightmare began and it is the sector that could easily kick it off again. The consensus may be that house prices have bottomed but note that there was a new surge in foreclosures last month and there is a nasty wave of mortgage rate resets (in which the rates will move up) to come in 2011.
A reflation of the housing sector in the US is vital for the banks and their still very iffy balance sheets. If it is reversed, there is every chance the financial sector could, as Charlie Morris of HSBC puts it, once again become “cryogenically cold”. That would count as proper bad news.
But this isn’t the half of it. What about China, the country the bulls are counting on to drag us all out of recession?
There, the government has just announced measures to cool the property market. Buy a second home in China now and you’ll have to put up a 50% deposit and pay a whoppingly high mortgage rate (at least 110% of the benchmark lending rate), for example.
It is pretty draconian stuff, which should push property prices down and have knock-on effects in the stock market. Shares in property developers and banks have already imploded.
Then there is Greece. Even the most passionately optimistic of optimists couldn’t find any good news in the fact the yield on ten-year Greek bonds went over 8% this week. I wrote here a few weeks ago that it was unlikely that the debacle would come to a happy end without the country’s creditors being forced to offer it a degree of debt “forgiveness”. That hasn’t changed – particularly given the fact that Eurostat (Europe’s statistical office) has just revised Greece’s 2009 fiscal deficit up to 13.6% (we are just behind them on 11.5%). Nor has the fact that Portugal, Italy and Spain could easily be next in the line of fire. Portugal’s bond yields are already regularly hitting new highs.
Regular readers will know I tend to see glasses half empty more often than most. Nonetheless, it is clear that the risks to the market are huge. Robin Griffiths, of Investment Research of Cambridge, points out in a recent note that late October to late May is “on average the best part of any year” and the time when investors are least likely to be bothered by the odd volcanic eruption or sovereign default. It is “amazing”, he says, to witness the extent to which markets can “absorb bad news” when they are on a roll, as they are now. They might “wobble a bit” here and there but, with bad news being fast forgotten, generally manage to carry on rising again.
However, now is the time to start being “very afraid”. Why? Because the worst possible time to buy equities is generally in late May. And the worst kind of late May to buy in is one in which markets are already expensive.
History shows that if you enter a market on a yield and price/earnings (p/e) ratio of seven, “you are virtually certain to do extremely well” on any time scale over three months. But enter on anything lower than a yield of 5% and anything higher than a p/e of 15 times and “you are likely to lose” over the same time scale.
Right now, the S&P 500 is trading on a p/e of 19 times and a yield of 1.8%. The yield has only hit this level twice before – in 1929 and in 2000. These are not good precedents – perhaps yet another reason not to wait until May to curtail your buying this year.
• This article was first published in the Financial Times