The sharp falls in global markets over the last month are due to more excessive fear and herd behaviour than any shift in economic and corporate fundamentals. Since their highs in July global stock markets have fallen by more than 20%, driven by a swathe of negative economic data, growing anxiety over sovereign debt and the after-effects of a US rating downgrade. Despite the sharp falls in equity markets, nothing much has changed over the last few weeks. After losing their prized AAA rating, US treasuries still remains a safe haven asset, this is reaffirmed by Moody’s and Fitch commitment to maintain their AAA rating. Anxiety over sovereign debt has been present since 2008 and weak economic data only confirms that economic recoveries following balance sheet recessions are typically slow and protracted. There have been no new significant economic developments that would justify such a dramatic fall in global equity markets in the last few weeks. In my view the markets are now undervalued, there are three reasons for this.
Firstly in the midst of the recent market falls, economic and corporate fundamentals seem to have been forgotten. Share prices of the top 20 FTSE 100 companies have fallen by more than 15% where as average forecast earnings have been downgraded by a modest reduction of 1.8% over the last month. Reductions in share prices have been nowhere near modest earnings falls, as a result there are now plenty more bargains available for investors looking to increase equity exposure. On the economic front the Federal Reserve’s survey of US banks senior lending officers last week showed a continued gradual easing in the conditions on which they make loans, the financial sector continues its ‘long hard slog’ to recovery. Purchasing manager’s surveys still suggest positive growth and demand for commodities remains robust. The market falls may be indicative of a slowdown, but a double-dip recession is unlikely and should it occur will be temporary given the growing presence of emerging consumers in countries like China and India. Also it is important not to read too much into the recent sell off because stock markets have had a terrible track record for predicting downturns, for example stock markets have predicted 10 out of the last 3 recessions.
Markets are driven by the interaction of greed and fear. In this case when fear swamps greed, markets tumble. Panic selling, as is happening now is a great way to lose money by buying high and selling low. In these circumstances it is important to look at the two parts of the brain which govern decision making. The first is the rational and logical part most suited to long term goals, the other part controls is emotional decision making. It is the latter part to which investors are using and are seeking instant gratification through panic selling; this has contributed to the sharp falls in global equity markets. It is worth invoking the wisdom of Warren Buffett “Be fearful when others are greedy, be greedy when others are fearful”. Markets in my opinion have fallen more than the fundamentals would warrant and therefore present opportunities for contrarian investors looking to boost their exposure to the stock market.
Lastly is the widening yield gap, this is the difference between the average dividend yield in the market and average bond yields. This is a classic indicator to measure whether a stock market is over or undervalued. In normal situations equities yield less than bond yields, this is due to equities potential for superior capital growth and because they are a hedge against inflation. Today the FTSE 100 dividend yield is just below 4% where as the 10 year gilt yields below 3%. When the yield gap goes into reverse, it usually presents a buying opportunity for those with the courage to take it. I wouldn’t describe it as a ‘screaming buy’ but certainly a buying opportunity and one in which investors can apply the ‘buy in dips philosophy’.
This is not a repeat of the global financial crisis in 2008 but an aftershock and an overreaction. John Templeton, one of the great contrarian investors of the past century said “Invest at the point of maximum pessimism”, I agree. Those considering increasing their equity exposure can adopt a ‘drip-feeding strategy’ to take advantage of the unprecedented volatility. Head of research at Hargreaves Lansdown Mark Dampier writing in their monthly investment newsletter said “I believe the biggest threat comes not from the market but from the human tendency to stick ones head in the sand”, therefore I believe investors sitting on the fence would come to look at this as a missed opportunity.