After a mid-summer lull, the global rally seems to be back on. Markets are bursting through those psychologically-important round numbers every day.
Last week, the S&P 500 closed above 1,000 for the first time since November. Hong Kong’s Hang Seng is above 20,000, up 80% from its lows. The speed of the recovery has been almost as impressive as the scale of the slump.
Can this carry on? Or is it too much too fast? I’ve always believed that timing turns in the markets is near impossible. The unsustainable can carry on much longer than you expect.
But it seems clear that markets are priced for perfection. Any disappointment could bring on a sharp fall. And while I think this rally could run for a bit longer, there are plenty of possible letdowns lurking later in the year…
The US economy isn’t fixed yet
The big cause for concern is America, as it has been throughout the crisis. GDP shrank at an annualised rate of 1% in the second quarter, according to the government’s first estimate. That’s a substantial slowdown in the decline compared to the first quarter. And thanks to the surge in government spending, the third quarter is almost certain to be positive.
But there were negatives beneath the good news. As David Rosenberg of Gluskin Sheff notes:
The details in today’s report left something to be desired. Consumer spending came in at -1.2% annualised, twice the decline expected by the consensus. This occurred in the face of gargantuan fiscal stimulus and leaves you wondering how this critical 70% chunk of the economy is going to perform as the cash-flow boost from Uncle Sam’s generosity recedes in the second half of the year.
Similarly, the fact that most big US companies are reporting improved earnings is not as good as it sounds. Most are beating expectations by cost cutting, not by raising sales. This gives you better numbers for a couple of quarters – but ultimately, cutting wages and firing staff hurts the overall economy.
And that spells trouble for Asia
You may ask why I’m focusing on problems in America. After all, Asia is already showing signs of a solid second-half recovery and – as I’ve argued before – can manage strong growth in the next few years even if the West remains sluggish.
But there are two reasons that we can’t ignore the world’s biggest economy. The first is that even though Asia can grow, it will be growing more slowly than it has done in recent years, because we won’t have the supercharger of debt-fuelled American consumption.
Unfortunately, many investors are banking on a return to normality in the US and thus a return to torrid, overheated growth in Asia. That’s not going to happen and at some point in the next few months, markets are likely to suffer a setback as that becomes clear.
Secondly, while Asian economies will be able to outperform the West on the way up, I don’t expect the Wall Street ‘leash effect’ to disappear yet. With the US still dominating the world economy and global capital markets, a fall there is likely to mean a fall elsewhere as well.
Next time round the cycle, I think it’s possible that Asian stock markets may be able to decouple from Wall Street a bit more – but it’s too early to expect that yet. And justifiably so – Asia has yet to prove that it can do well in the face of a sluggish US economy. Until that’s proven, investors should remain cautious.
For this reason, I’m concerned about the speed of the rebound in Asia. I’m not talking about the clearly overheated Chinese domestic market (now on a price/earnings ratio of 33 and a price/book of 3.7) or India (p/e of 18 and a p/b of 3.3), which are obviously overstretched. Most of the region has come back too fast.
The MSCI Asia ex-Japan is now back to a p/b of 1.9 after just 10 months. Historically, this is a mid-range valuation for Asia, as the chart below shows. Investors seem to be pricing in a pretty rapid recovery.
Investors are taking on too much risk
That doesn’t mean there’s no value in the Asian market – I still see plenty of interesting prospects. But much of it is concentrated in the apparently duller stocks that have lagged the rally so far. That means the banks, the telecoms, the consumer staples firms, for example – many of which offer an attractive combination of a long-term growth story and a big dividend.
These have been ignored as investors flood into more volatile stocks – pure growth plays and cyclical stocks. Back in the trough, when everyone was panicking and switching into defensives this made sense – many perfectly adequate firms were priced for Armageddon and offered a very favourable risk-reward trade-off at that level. For example, stocks such Kingboard Chemical and Jinpan International (which I first profiled here: What credit markets are telling us about Asia in 2009, and here: A little-known way to profit from China’s infrastructure binge, have done very well since then).
But now, investors continue to flood back into risky assets, for example junk bonds. In the US, the Merrill Lynch High Yield Master II Index is up 38% since March, as you can see below. More widely, the reopening of the credit markets is allowing many leveraged buy-outs that should be put out of their misery now to refinance and stagger on a bit longer.
As Michael Lewitt of Harch Capital Management puts it:
Junk bond investors never seem to learn their lesson; they fight to get at the front of the line to buy the lowest quality, highest quantity garbage that corporations (mostly those controlled by private equity firms) rush to sell when complacency is at its highest. They moan and groan when they suffer losses but they are right back at the trough the next time the same kind of gruel is served up by the same sellers.
Others are committing the cardinal sin of overpaying for growth, rushing into the hot sector and hot stock at ridiculous valuations. For one example, take the electric car sector. My colleague Eoin Gleeson wrote a cover story on this for the latest issue of MoneyWeek: Electric cars: on the road to a cleaner, greener future (if you aren’t already a subscriber, you can claim your first three issues free here).
One stock he doesn’t include among his tips is Chinese firm BYD, a battery and electronics specialist that is moving into this business – and for good reason. I was looking at this company as a possible investment in September last year. Then Warren Buffett took a 10% stake – and the shares immediately doubled (see chart below).
While it was good to have the world’s most-famous value investor back up my instincts about the firm, it no longer looked such an outstanding bargain at that price. So I decided to delay profiling it until the Buffett-induced euphoria faded a bit and the shares eased back. Unfortunately, that never happened. With the firm now on investors’ radars, the shares have since trebled again, as the chart below shows.
BYD now trades on a p/e of 60 times forecast earnings. Even for a promising company with good technology, that’s a crazy valuation. If – and it remains an if – electric cars are the way forward, everyone in the brutally competitive auto industry will be piling in to it. There is no certainty that a relatively small first mover will remain in the forefront of it, let along manage the sales to justify those kinds of valuations. It may – but there’s no margin of safety in that price.
The rally will end when the recovery disappoints
So if this rally is headed for disappointment – or a least a sharp setback – when will that happen? My hunch is that it can run on for a while longer – we will see that third-quarter US GDP growth and possibly a positive print in the UK or Canada or elsewhere as well.
On top of that, we’ll probably have good third-quarter earnings numbers (due to cost-cutting again) and maybe positive news into the fourth quarter. Then we may hit trouble later in the year when it becomes clear that this is no V-shaped recovery but a long slog, with the possibility of a double-dip in growth next year.
That said, I don’t claim to be able to predict the market, because I’ve never met anyone who consistently can. So while I watch the twists and turns, I only tend to worry about that when it’s clear that almost everything is overvalued and a big sell-off is on the cards – as in 2007, when finding value was almost impossible.
At other times, I would ignore the broader market and just focus on finding unfashionable, undervalued stocks – of which there are still plenty about. I have a few ideas lined up and I hope to be able to profile one for you next week.
In other news this week…
| Market | Close | 5-day change |
|---|---|---|
| China (CSI 300) | 3,555 | -4.8% |
| Hong Kong (Hang Seng) | 20,375 | -1.0% |
| India (Sensex) | 15,160 | -3.3% |
| Indonesia (JCI) | 2,349 | +1.1% |
| Japan (Topix) | 957 | +0.7% |
| Malaysia (KLCI) | 1,185 | +0.8% |
| Philippines (PSEi) | 2,783 | -0.5% |
| Singapore (Straits Times) | 2,602 | -2.2% |
| South Korea (KOSPI) | 1,576 | +1.0% |
| Taiwan (Taiex) | 6,869 | +3.0% |
| Thailand (SET) | 644 | +3.2% |
| Vietnam (VN Index) | 481 | +3.0% |
| MSCI Asia | 99 | -1.6% |
| MSCI Asia ex-Japan | 428 | -1.7% |
Australian banking group ANZ has agreed to buy a number of Asian assets from Britain’s troubled Royal Bank of Scotland. ANZ will pay US$550m – roughly book value – for a range of business in Hong Kong, Indonesia, the Philippines, Singapore, Taiwan and Vietnam. The deal will help ANZ compete with larger rivals HSBC and Standard Chartered in building a major regional banking business. Standard Chartered is reported to be close to buying RBS’s China, India and Malaysia operations for around US$200-250m.
State-controlled but Hong Kong-listed China Mobile, the country’s largest mobile telecoms firm, is reported to be planning to list on the Shanghai stock exchange next year as part of the Chinese government’s plans to set up an international board in the domestic market. London and Hong Kong-listed HSBC is also said to be interested; while the bank is reported to be intending to raise around US$5bn, new capital would be less important than strengthening its Chinese ties by becoming one of the first foreign firms to list there.
And the outlook for the Indian monsoon seems to be getting worse. Rainfall so far has been 28% deficient, raising the risk of a severe drought. A successful monsoon is vital for the India agriculture sector, which accounts for around one-fifth of the economy and has helped prop up growth during this slowdown through robust rural spending.
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