With the US Federal Reserve pessimistic about a recovery in the next two years, John Stepek and David Stevenson ask where investors can find value.
Investors had a nasty flashback to 2008 this week and last. Amid further panic in the eurozone, and a downgrade of America’s credit rating by Standard & Poor’s, stockmarkets saw their worst falls since the financial crisis.
On Tuesday, US Federal Reserve chief Ben Bernanke stepped in. As he promised to keep interest rates at close to 0% until at least mid-2013, stocks rebounded and the dollar fell. We’re not convinced that this is going to last, though. Markets were due a rebound in any case after such brutal falls. Also, hopes that this is the precursor to another batch of quantitative easing (QE) might be over-optimistic. Three of Bernanke’s colleagues were against the move, which is an almost unheard-of level of dissent among Federal Reserve members.
But most importantly, this is thoroughly depressing news. The Fed has virtually admitted – by planning to keep rates this low – that it sees no hope for a vigorous US recovery for the next two years. That sounds an awful lot like many investors’ worst-case economic scenario – Japan.
And it’s this slowdown threat that’s had the markets running scared. As Albert Edwards of Société Générale put it this week, the “meltdown has nothing to do with the S&P downgrade of the US… The simple fact is that the global economy is falling back into recession – or indeed is already in recession”.
The bad news is that the ‘recovery’ has hardly been barnstorming. American unemployment is still above 9%, even on the very forgiving headline official measure used by the government. Indeed, notes Jeremy Grantham of US fund group GMO, “to this point, there has never been such a weak and slow recovery from a steep decline”. And yet, now we could be heading for another recession before we’ve really recovered from the last one.
As the chart below shows, when the US economy falls below 2% GDP growth, a recession has almost always followed. This is “exactly the Ice Age template that Japan showed us”, says Edwards. “A fragile recovery undermined by private-sector deleveraging collapses as a semi-bankrupt government tries to rein in runaway deficits.”
So why has the recovery been so frail? In short, because it was fake. You have to look at the build-up to the crash to see why our problems are far more entrenched than your average cyclical recession would suggest. Edwards notes that during the boom years, “a massive transfer of income to the very rich has occurred while middle-class real incomes stagnated. The middle classes only tolerated this because central bankers created housing booms to keep [them] borrowing and spending to give them the illusion of prosperity and stop them from revolting”. Whether or not you think this was a deliberate policy, or simple short-sighted vote-grabbing, it’s certainly a good description of what actually happened.
After the bust in 2007/2008, this “unsustainable” private sector debt burden was “transferred to the public sector… to prevent the adjustment to the depression-era reality that the debt-unwind would undoubtedly have brought about. Yet those debts are as unsustainable in the hands of the public sector as they were in the private sector”. And there’s no way for consumers to take up the slack when states have to cut back. With real wages still falling in real terms, and individuals cut off from lending or actively trying to pay off debts, “how can there be sustained gains in broad consumption?” asks Grantham. As James Saft puts it on Reuters, “this is a balance-sheet recession, and it will be grinding and ugly”.
So it’s easy to see why Bernanke is gloomy about prospects for America. What is harder to see is what he can do about it. Few investors by now were expecting an imminent rise in interest rates. And while it’s possible that he’ll announce more QE, the last batch may have done more harm than good by driving up commodity prices and causing consumers even more pain as their living costs surged.
So what does this mean for markets? That probably won’t stop markets from rebounding if Bernanke hints at more QE at the meeting of global central bankers in Jackson Hole, Wyoming, later this month. Albert Edwards reckons there will be some sort of retest of the 1,250 level on the S&P 500 “before the market ultimately meets its date with destiny”. However, “expect the real fireworks to occur when the adrenalin rush of QE3 wears off even quicker than QE2”.
So how far could the market fall? John Higgins at Capital Economics notes that judging by the cyclically adjusted price/earnings (CAPE) ratio (which smooths out earnings over a decade, and so factors in rises and dips in the broader economy), the S&P 500 is expensive – the CAPE is currently around 19.3. The average since 1900 is 15. If it fell back to that level, we’d be looking at around 870 on the S&P 500. But on average, the CAPE has fallen back to a low of 11.3 in past recession-induced slumps. That would give you a value of 655.
Higgins is less bearish than Edwards, believing the US will avoid recession in the near future and be stuck with weak growth instead. “An economy in a rut would have a less detrimental impact on stock prices than one in recession, but it would hardly be good news.” His view is that the S&P 500 will fall to 1,000 by the year-end, which is similar to Grantham’s view that ‘fair value’ on the S&P is around 970.
The point is, this overvaluation all points to the market being vulnerable to further falls. As Grantham puts it: “Keep your head down… for the foreseeable future… The market has this always disturbing habit of ignoring the obvious and ignoring it some more, until, in the blink of an eye, it doesn’t.”
So what is worth buying? Grantham’s favoured portfolio is very similar to our own – he likes forestry and farmland and reckons commodities will be worth looking at, but only after a sharp correction.
As for global stockmarkets, like us he favours Japan, given that even at current levels of profitability – which he expects to improve over time – it’s “a bit cheaper” than other developed equity markets are right now. On an individual stock basis, he still likes “quality stocks”, which are priced to give “approximately a 4.5%-5% real return, which I think is acceptable for low-risk assets”. They are also likely to fall by less than other stocks, even if markets do crash. We would agree with that – and below, David Stevenson takes a look at some of the defensive blue-chip stocks you should be buying, or at least putting on your watchlist.
Defensive blue-chip stocks to buy now
If you’re looking to put money into the stockmarket, the latest big sell-off is throwing up chances to buy shares that are much cheaper than they were two weeks ago. Sure, there’ll be lots of ongoing volatility, and hitting the absolute low will be almost impossible. But on a long-term view, disciplined buying now could look a very smart move.
However, you do need to make a plan. So, it’s important that you first compile a ‘watch list’ of shares that you’ve had your eye on, but which you didn’t buy before because you wanted them to drop back.
Second, don’t listen too much and too closely to predictions about what will happen next. No one really knows, so most commentators simply frame their forecasts around what’s just happened. In fact, the opposite is more likely. That in turn means that the best days to buy will be when everyone is feeling most gloomy.
Third, once you’ve decided on your list of stocks to own, stick to it. Don’t chop and change your choices – it’s too easy to get confused about what you’re trying to achieve.
So where to start? We’ve been arguing for months that cyclical stocks that depend on economic expansion for their earnings are vulnerable. With growing question marks now cropping up over global growth, we see no reason to change our tune even though many of these cyclicals have borne the brunt of the recent selling.
That means we are sticking to our guns – we are convinced that good-value, defensive, blue-chip shares – preferably with decent yields thrown in – are the place to be. And in a week when the US has lost its top-tier triple-A rating, what better place to start than in that country – with a $170bn market-cap giant whose sound finances put the US government to shame.
US blue-chip Johnson & Johnson (US: JNJ) gets nearly two-thirds of its revenues from healthcare products and owns a portfolio of household-name brands. Earnings per share (EPS) have grown for 49 years running, rising by an average 11% a year over the past decade. The dividend has been hiked for 27 years in a row.
Looking forward, net profits are set to rise by at least 6% a year until 2013. Yet the firm’s shares have still been dragged down almost 10% over the last month. They now sell on a forecast 2011 p/e of just 12.2, and prospective yield of 3.7%, which is expected to rise to 4% in 2012. For a US stock, that’s way above an average payout.
Further, how about this? Credit default swaps (CDS) measure the chance of a company defaulting on borrowings – the higher the price, the more likely a default. At the end of March 2011, Johnson & Johnson had no net debt – in fact its balance sheet held $9bn of net cash. That’s pushed the company’s CDS to well below those of the US Treasuries – meaning it is actually seen as a much safer financial bet than the country itself.
Even less expensive in the healthcare sector is US drug maker Pfizer (US: PFE). The company’s share price has dropped by 19% since the start of June. Yet Pfizer is on a current year p/e of below eight, which is forecast to fall further in 2012. What’s more, the prospective dividend yield is 4.6%. For a business that’s restructuring to maximise the value of its assets, with a number of promising pipeline products, that’s cheap.
Also among ‘big pharma’ firms, and for a stock that rates even higher than Johnson & Johnson CDS-wise – and is also great value – take a look at Merck (US: MRK).
Meanwhile, here in Britain, pharmaceuticals giant AstraZeneca (LSE: AZN) has tumbled around 20% in just over a month. Amazingly, the company is now on a current year p/e of only 5.7, with a prospective yield – covered 2.5 times by earnings – of a whopping 6.8%. That’s got to be a steal.
If you prefer a fund, one of the most defensive areas you can buy into is the US ‘consumer staple’ sector. This is made up of companies such as food and drink makers whose products are seen as essential, making them some of the most stable businesses around.
The Consumer Staples Select Sector SPDR Fund ( US: XLP ) is an exchange-traded fund (ETF) that invests across the range of US consumer staple firms. It’s fallen almost 10% in the latest carnage. But it can do spectacularly well compared with cyclical sectors when markets are going through a very rough patch.
The consumer connection leads back to this side of the Atlantic. One of our long-term favoured areas has been food retailing. The sector keeps managing to grow profits, cash flow and dividends even when our economy is sluggish. But shares in both Tesco (LSE: TSCO) and Sainsbury’s (LSE: SBRY) have now been lowered to p/e multiples of just above ten, and prospective yields of 4.3% and 5.6% respectively. Worth a look.
Talking of old favourites, Scottish & Southern Energy (LSE: SSE) – the owner of half the Scotland and Southern gas distribution networks – has also been a utility we’ve liked for a while. With the shares down around 16% within the last month, we like it even more now. And on just 10.3 times current year earnings, and a tasty 6.6% prospective yield with decent dividends increases in store, why not?
UK telecoms giant Vodafone (LSE: VOD) was looking good even before the latest market sell off. It has just said that it’s received a £2.8bn windfall dividend from US subsidiary Verizon Wireless. But with the shares 10% lower than in the end-July announcement, the company is now looking even better value on a sub-ten p/e and a prospective yield of more than 6%.
Finally, worldwide commercial insurer RSA (LSE: RSA) has lost 20% of its market worth since late July. That has lowered the firm’s price/stated book value ratio to just above one, which is the lowest level since 2005. Meanwhile, RSA is selling on a p/e multiple of just 7.5 – with a stonking 8.5% prospective yield as well. This looks a great time to take advantage.
How to read the market’s ‘fear’ gauge
How do you tell just how much financial stress is building up in the system? One good way is to watch the HSBC Financial Clog Index, which is composed of four equally-weighted risk indicators.
The first measures bank risk. You know banks are getting fretful when they won’t lend money to each other – because they’re worried about getting it all back when needed. So the price of money rises, as measured by the TED spread – the gap between rates on inter-bank loans (seen as riskier) and on short-term US government bills (seen as safe) – and the Libor-OIS spread.
Here Libor is viewed as riskier, while overnight index swap (OIS) rates, which are based on Fed fund rates, are seen as safe. The wider these spreads go, the more fear there is.
Then there’s financial firms’ default risk, as measured by credit default swaps (CDS) – insurance for investors to buy if they fear a firm may be going sour. The higher a CDS price, the more risk there is. Next there are mortgage agency credit spreads – these are barometers of how many US home-loan borrowers might default.
Finally, there’s stockmarket ‘implied volatility’ – the chance of shares rising or falling from a given level – as measured by the VIX index, which provides insurance against big market moves. A rising VIX means share investors are becoming more worried.
And as the above chart of the ‘inverted’ Clog index against the FTSE 100 shows, the more it rises – ie, the lower the blue line goes on the chart – the more concerned we all should be getting.
• This article was originally published in MoneyWeek magazine issue number 550 on 12 August 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.