It takes two to make a market

Thursday, 3rd September 2015 10:56 - by David Harbage

The old adage implying that there will be both buyers and sellers in a healthy market – if only to determine the price – comes to mind following the turbulence seen in global stock markets over the past fortnight or so.

Call them ‘bulls’ and ‘bears’, or optimists and pessimists, but there have undoubtedly been some very strong two-way pulls in equity valuations. Essentially as investors try to assess what’s ‘in the offing’, insofar as the world’s economic landscape is concerned – as suggested in this writer’s Blog of 24 August 2015 entitled ‘A critical week ahead’. The catalyst for this reappraisal was a deterioration in manufacturing data emanating from the world’s second largest economy, accompanied by unexpected devaluations in the Chinese currency and a sense of “Where else, beyond China, can the world’s growth come from?”

On balance, this author is a natural bull – seeing a half glass as being half full, rather than half empty – but hopefully am also mindful of the downside risks to consensual market wisdom or his own perspective. Certainly not wishing to adopt a ‘King Canute’ stance or retain deep seated prejudices about what is happening in the world, which could erode the worth of hard earned capital. With this in mind, this article seeks to take a further look at ‘what the market might be telling us’ in the turbulent month of August.

That the implied or anticipated volatility in US equities (assessed by reference to the Chicago Board Options Exchange volatility index, known as VIX, measuring expected 30 day volatility on a number of equity indices – such as the Standard & Poors 500) had risen dramatically from about 15 over the past two years to 35, suggests a number of things. First, investors have little idea about where stock prices are going in the very short term: evidencing a lack of confidence or uncertainty about immediate news flow and immediate term prospects. Secondly, the marked pickup in the VIX suggests the magnitude in share price movements is expected to be much higher than normal: which has been played out in the recent ‘rollercoaster-like’ behaviour of stock indices. Third and finally, the VIX index has frequently been described as an ‘index of fear’ or a ‘fear gauge’ – reflecting the level of investor concerns – and certainly a high reading implies a pickup in anticipated risk.

Historically, a rise to the 35 level in the VIX on the S&P 500 index would indicate that the United States was in a recession, or suggest that a pronounced economic downturn was imminent. That markets hate uncertainty, and being surprised, is a truism. The huge fall in oil and gas prices over the past year (for instance Brent crude oil has fallen from US$118 in June 2014 to $42.25 last week and a hike to $50 at the time of writing this blog) – allied to the inherent volatility over that period – has caused investors to worry, notwithstanding any potential benefits. In similar vein, other raw materials like copper and iron ore have plunged further than almost any commodity expert predicted. Yes, reflecting lower demand from emerging economies like China, but also higher output from the producers of these industrial minerals. Raising fears of deflation and further dislocation, post the 2009 crisis, in the economic and financial infrastructure.

A double-digit fall in any prime asset market’s worth merits closer inspection (for instance, house prices in Dubai dropped by 12.2% in the year to 30 June 2015 – but someone else can comment on that one), in terms of the cause and potential effect. By reference again to the US equity market, a correction of 10% or more is relatively rare (with only 13 such instances in the past 65 years) but typically these coincide with a period of flirting with, if not being in absolute, recession. After a long bull run in equity markets, which has seen reasonably stable conditions (only two spikes up to 35 in the VIX, until this August, since 2009), it is not surprising to see investors unnerved by recent developments. Last month’s 10% correction in the UK equity market is the first for four years, whereas a fall of such magnitude (most commonly occurring as part of a rising market) has typically arisen every 18 months on average over the past 70 years.      

Whether the current China-induced wobble is set to continue, worsen or gently improve/stabilise remains to be seen. Certainly, most economic data appears to suggest a more polarised, if not a two-speed dimension, economic conditions with investment and manufacturing slowing in China, the Eurozone, here in the UK and also in the United States - but service businesses and personal consumption remaining robust. Looking closer to home, across the relative valuation of the UK equity market versus the current price of stocks on other major bourses, investors can draw comfort from the FTSE100 index’s more lowly rating (or valuation) of prospective earnings and dividends. On a forward looking price-to-earnings (PE) ratio of 12 times calendar 2016 profits, London’s listed businesses compare favourably with the Beijing exchange and New York’s Wall Street whose leading companies are on a PE multiple in excess of 20. Concerns about the quality of economic data, and corporate disclosure in particular, would make this observer wary of Chinese valuations (notwithstanding the significant recent retracement). US stocks will often merit a higher rating than our equivalent domestic firm, given the former’s superior track record in asset and earnings growth, but the differential appears to have widened too far in favour of America’s stock exchange listed firms. Certainly recent trading results from US Inc. and, perhaps more critically, profit projections for next year suggest better value may reside in the UK or the European equity markets (both of which strongly feature multinational businesses).

However, we conclude this article with another well-known saying that, “When Wall Street sneezes, we catch a cold”. This suggests the UK stock market is unlikely to be immune from any further sell-off in US equities. In current uncertain times, investors need to be more discriminating and re-assess their circumstances, objectives, views and mix of assets – as discussed in the 10 August article ‘We are into the summer season – time for a portfolio review’. As an example, they may want to consider the polarised performance of house builders within the FTSE100 (namely Barratt Developments, Persimmon and Taylor Wimpey – set to be joined by the Berkeley Group) and multi-product mining giants (like Anglo American, BHP Billiton, Glencore and Rio Tinto) in 2014 and in 2015 to date. In particular, has past relative performance been justified, will it continue to diverge (in both/either weakening or recovering markets)? While these miners are clearly experiencing the adverse impact of slower global demand, can the particularly domestic business activity of home building remain immune to any further setback in investor confidence and the potential for another, more widespread,  sell-off in global stocks?            

Writen by David Harbage

3 September 2015

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The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.