Thoughts on the market's Sell-off

Friday, 12th October 2018 07:31 - by David Harbage

1. Not surprised - to see theUnited States equity market’s weakness as, after one of the longest bull runs and a 50%+ rise in the Standard & Poors 500 index (the best indication of that market) since the beginning of 2016, valuations appeared increasingly stretched. In particular, the so-called FANGs (taking the first letter of the largest technology firms) stocks appeared reminiscent of the turn of the millennium TMT (technology media telecom) euphoria, when their worth bore little relationship to their profits or assets.

2. Not surprised – that a contagion effect (“when Wall Street sneezes, we all catch a cold”) impacts almost all other stock markets, irrespective of their interaction, local or relative valuation – for instance the UK equity market (which is priced, by reference to profits produced, at half the level of US shares) has also fallen back sharply in October (FTSE100 from 7,500 to 7,050 at the time of writing). It may not be logical: driven more by emotive forces, than a fundamental appreciation of the future worth of earnings or dividend income.

3. Outlook is clouded in uncertainty - the perennial balancing of risk-reward is biased towards being cautious in the short term, as the two key factors in assessment of businesses feature immediate negatives. These two factors are the fundamentals (trading outlook, balance sheet etc.) and the price the market puts on such listed businesses. In terms of the former, the world faces a number of significant uncertainties, trade wars (notably US-China) and political instability (populist, reversing globalisation, Russian influence). In economic terms, global GDP of circa 4% this year and next is very healthy, with corporate profits (especially US, post tax reforms) to be robust, although economic activity is likely to slow in the final quarter of 2019.

4. Relative valuation is deteriorating State-side – equity’s appeal should be assessed by comparison with prime alternatives: overnight cash rates and longer term bond yields, as well as other, less liquid income-producing assets such as real estate. The central bank in the US has raised interest rates more quickly than most commentators anticipated this year and the Federal Reserve’s intimation of future hikes has ‘spooked’ the market – with US government 10 year bond yields jumping up to reach 3.2% over the past week - which compares with the 1.7% dividend yield offered by the local S&P 500 index.

5. Turning to the UK outlook: uncertainties abound – in particular political and economic, by reference to trade disruption post Brexit and the thin authority that accompanies the parliamentary margin of the current Conservative government.

While the outcome of Brexit is critical, our media appears to focus on the negatives and disregard the fact that European exports to the UK far exceed the trade flowing in the opposite direction. Indeed the European press will give a very different perspective, but nonetheless pro-EU politicians seem determined to ‘cut their own noses off to spite their faces’, in order to dissuade other countries from following the independence route. Leaving politics aside, be it possible, this writer believes that the UK’s huge trade deficit with Europe can only mean that a sensible solution can be found or that otherwise the UK will trade more freely with the world’s ex-EU countries whose economic growth comfortably exceeds that of Europe.

By contrast, the popularity of the Labour party – 1 October voting intention poll showed 36% support, despite its leader being subject to much personal criticism , versus Conservative 42%, Liberal 9% - might be a source of equal concern for equity markets. As the recent party conference, Labour endorsed the prospect of taking a 10% equity stake in listed companies to put a worker representative on the board and a Corbyn-led government would almost certainly mean major hikes in personal tax (60%?), corporate tax (40%?) as well as full state ownership of critical assets. Such a capitalist-unfriendly administration would be very bad news for the stock market, reviving memories of 50 years ago. Unlikely perhaps, but never say never in the current political clime.

6. UK equity’s relative valuation appeals – by contrast with the US, as cash returns and longer term interest rates (by reference to the risk-free rate offered by gilts) have less upward momentum and face less economically-induced hiking pressure. Cash pays 0.75% and the 10 year government stock (colloquially known as a gilt) yields 1.7%, while the FTSE100 index offers dividend income of 4.25%, today. Consensual estimates for Bank base rate in one year’s time is 1.0%, the ten year gilt 1.9% and dividends from the overall UK equity market are forecast to grow by 5% (in sterling terms, aided by the weak £). Having said that, both internal external factors – think inflation, in particular - could change the relative and absolute landscape.

7. Within equity, ‘times, or trends, may be a changing” – the current ‘shake-up’ in markets is likely to give investors a ‘wake-up call’ which could prompt major changes in thinking and strategy. Globally, there has been a clear preference for Growth-oriented (and priced accordingly) businesses over company stocks whose prime attribute appears to be their Value over the past five years – as economic activity has accelerated, and corporate revenues appear more assured (stock market commentators use terms such as quality, measured by reference to reliability, in this regard). In addition, closer to home and post the EU referendum of June 2016, investors have preferred to own multinational, non-£ earning companies rather than pure domestic businesses. Markets will always have trends, some more obvious than others, but over the past two years or so the dispersion in market price (probably best evidenced in earnings multiple) between international growth stocks and UK-centric company shares has grown to become huge.

While investors await the outcome and outworking of Brexit, domestic firms may not regain their previous pre-2016 lustre, but the Growth versus Value issue is set to be addressed more urgently – given that the former frequently feature ‘stretched’ valuations (by investor optimism of on-going operational success), which might now wane, resulting in reinvestment into less racy, economically insensitive stocks (such as utilities or telecommunications). In due course, this author expects migration towards domestic companies – where the investor has confidence in the business model and fundamentals – as well as to those that appear to be undervalued, to accelerate.

8. A market ‘Sell-off’ or ‘correction in valuation’ should not be viewed as the moment to press the ‘Panic’ button and make for the Exit. Often, little will have changed about a company’s prospects to justify a sharp reduction in its market price. Subject to being comfortable with the business owned – and, in particular, with its attraction relative to other kinds of asset (most obvious in its income production) – the prudent long term investor will take advantage of depressed valuations to pick up bargains. In times of fear, market makers  will often indiscriminately cut prices in order to frighten investors into disposing of their shares, as well as appreciate that some derivative traders will have been carrying financially geared positions and be viewed as ‘forced sellers’ further depressing prices.

9. The long term private client investor can benefit from such artificial temporal prices – subject of course to being comfortable with their risk investments (see the author’s 13 August blog “How much of my wealth should I put in shares?”). Many individuals making pension contributions on a monthly, as well as more substantially on an occasional, basis should welcome such opportunities to buy more assets or shares (than would otherwise have been the case without the market weakness).While the immediate worth of their (increasingly self-administered, nowadays) Pension Plan might show a decline in worth, this is of little consequence until a withdrawal from the plan is required. 

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.