‘A very good year?’

This is a decidedly unpopular bull market. New objections to investing in equities continue to emerge. We read every day that the market rally has gone too far and that a significant pullback or a resumption of the bear market is imminent. These noisy bears tend to fall into three camps: those who are hoping for a better entry point; those who are looking for confirmation that their entrenched bearishness was right all along and those who on “up” days are in the former camp and on “down” days in the latter. Market noise tells you how consensus is positioned: at the moment it is on the outside looking in, with its nose firmly pressed against the glass. It is understandable the bear market of 2007-2009 should have shellshocked investors but it has also engendered something of a “Peeping Tom” approach to financial markets: lots of fantasy about frenzied participation but in the absence of the necessary risk appetite, destined to always watch the action from a distance.

After a severe bear market it is normal that investors have less money to invest and are more concerned about the preservation of what remains of their wealth. This potentially leads to a mentality where volatile assets are shunned whatever their price. While there is an abundance of financial history written on how rising prices de-sensitise investors to value – investment manias - there is relatively little analysis of how this process works in reverse when value is ignored because of painful memories of losses. Understanding how psychology in economic crises creates investment opportunities for the recovery is as important as any understanding of what caused the crisis in the first place. Whilst economic crisis will be very familiar to those emerging markets investors who remember that the 1990s was rather less kind to their asset class, stock-market operators in developed markets with experience of what an economic crisis (as opposed to events such as the internet bubble of 2000 or the “Crash” of 1987 which had relatively little impact on the real economy) looks like in stock-market terms are now either retired or dead. The last developed world economic crisis, when governments and central banks lost any semblance of control over the economy was more than three decades ago in the early 1970s.

Then, the combination of an OPEC oil embargo, inflation and recession caused corporate profits and stock markets to fall worldwide. But in the UK things were uniquely poor. In 1973, the imposition of a 3-day working week in the UK saw the FTSE All Share Index fall 31%. In 1974, with the miners on strike, Prime Minister Heath failing to win an election he had called over “who governed Britain” and the new Labour Chancellor of the Exchequer introducing an emergency deflationary budget (including a top rate of income tax of 83% and 98% on investment incomes) the FTSE All Share Index fell another 55%. The panic in holding financial assets was summed up by renowned investor Jim Slater at the Slater Walker AGM of 30th May 1974: “Many people in recent months have found you cannot always turn property into cash; you cannot always turn large lines of shares into cash; you cannot always turn pictures into cash. Cash you can always turn to other things”.*

But to paraphrase Slater, cash must eventually be turned to these other things. And in 1975 it was equities with the FTSE All Share Index returning +139% - its best ever year. And as with today’s recovery this new bull market was viewed with great scepticism. Looking through some back copies of the Financial Times from 1975, we can see that although the names have changed, the commentary is remarkably similar in tone to 2009. After the first day of trading in 1975, the FT’s stock market commentator Jay Palmer noted that “the odds against any sustained bull mood in the near future seem unfortunately overwhelming.”** The following two months saw the FTSE All Share Index double in value and the S&P 500 rise by more than 20%, yet Palmer was unmoved: “Wall Street very wisely remains unconvinced that this surge is necessarily anything more than a technical and reversible reaction.....The sheer depth of possible bad news – more economic gloom plus a stream of terrible corporate profit results and possibly even a few major bankruptcies – does make it likely that Wall Street will move lower before going much higher”.***

Yet by December 1975, Palmer was able with hindsight to have identified one of the greatest buying stock market opportunities of all time: “Looking back over the past 12 months, it is clear that Wall Street deserves to be described as a bull market. Up from a low of around 600, the market has regained virtually all of the ground lost during the previous year. While many missed the market bottom and maintained high liquidity through to the spring and summer the caution born of the preceding two-year slide now appears to be long gone. Most funds are now fully invested with current arguments centring on whether equities are a better investment than bonds rather than the timing of the apocalypse.”† If we look at annual stock market returns in the US, UK and Europe over the last 50 years (see below) we can see both the exceptional nature of the UK in 1975 but also that good stock market years invariably follow very poor years. Buying the market after it has fallen significantly when an economic recovery is underway has been an excellent long-term investment strategy. Underestimating the volatility of annual market returns would have been a disaster.

Are there any general rules we can prescribe about exceptional years for the stock-market? In his study “It was a Very Good Year” Martin S. Fridson examines the circumstances behind the S&P 500 composite index returns of 35%+ seen in 1908, 1915, 1927, 1928, 1933, 1935, 1954, 1958, 1975 and 1995 and attempts to explain what causes “very good years” for equity market returns. He concludes that although there are often divergent factors at play, there is a “Winning Combination: Depressed Prices + Sudden Credit Easing….When a high volume of credit suddenly enters the US financial system, whether through Fed action or as the result of some other nation’s central bank policy, it must find an outlet. On several occasions during the twentieth century, capital markets have provided that outlet. In these situations, inflation has occurred in financial assets, rather than in goods and services.....All in all, it’s reasonable to infer that Federal Reserve Chairmen feel justified in temporarily setting aside the battle for price stability when some overriding economic concern arises. Spotting such an overriding concern, at a time when stock prices happen to be depressed, represents the best hope for getting a jump on a Very Good Year in the stock market”.††

If the winning combination for stock markets is “Depressed Prices + Sudden Credit Easing” then 2009 fits the formula perfectly. As we can see from the graph above, at the start of 2009 credit spreads were as wide as they had last been in the Great Depression since when they have halved giving credit investors their best ever year for returns. Even though spreads remain elevated in absolute terms, because interest rates are near to zero the cost of borrowing for many – though by no means all - companies (corporate bond yields) and individuals (mortgage rates) is at all time lows. With this considerable stimulus from credit easing, many investors have become concerned that this will lead to inflation in the price of goods and services. Others continue to worry about a Japanese style deflationary scenario. It is possibly that both are equally wrong. As Fridson has suggested, is it not more likely that this inflation is experienced first in financial assets, particularly in view of the longer term deflationary forces unleashed by globalisation? Could it be that developed market equities having suffered a decade of de-rating get re-rated in a zerointerest rate environment?

Returns from the market low in March really need to be put into some kind of longer term perspective. Even now developed market equities still trade at the same level as in 1998 and would have to rise more than 65% to get back to their 2007 (and 2000) peak. Given that share prices – with no re-rating – should only track corporate profits and corporate profits without a structural improvement in profitability can only track GDP growth, it should come as no surprise that the best time to buy equities are when share prices (and corporate profits) have underperformed trend GDP growth. Looking at the UK economy since 1998 we can see that GDP has increased by 30%, wages by 50%, house prices by 130% but that corporate profits have only risen by 25% and the equity prices have given no return.

If we do the same analysis on the US economy we see that since 1998 house prices have now only risen in-line with wages (+50%). On the other hand GDP is up 30%, the stock market has delivered no return and aggregate corporate profits (including bank write-offs) have actually fallen by 80% over 11 years. Even after the 50% return from the market bottom, it has already been a lost decade for developed market equities. Should we really worry that an asset class which trades at a ten year low is overbought?

There has been a tendency in recent weeks for even some of the bulls of equity markets to see the market rally as solely a “governmentsponsored liquidity event” to the exclusion of any economic recovery or absolute value in equity markets. Although much easier for the bears to digest, a multiple expansion of financial assets in a zerointerest rate environment is really only part of the story. Leading economic indicators – as opposed to lagging ones such as unemployment – are consistent with not only all major economies having already emerged from recession but with above trend GDP growth by year-end. This is likely to be the strongest period of synchronised growth between the US and Europe since (you guessed it) 1975.

Bears will complain that this will be “low-quality” economic growth based on one-off inventory re-build, but just as the one-off nature of the inventory liquidation over the last year has been very real in its impact on industrial production and unemployment, so bringing inventories back to more normalised levels cannot be dismissed as just some kind of statistical event with no meaningful impact on the real economy. Those who dismiss the possibility of economic recovery are also ignoring the positive feedback loop that financial markets can generate for the real economy. As asset prices continue to recover, banks can have more confidence that their capital bases are sufficient to cover likely bad assets. This should diminish the urgency for banks to de-lever their balance sheets and should engender a less risk adverse attitude to new lending. This is how the vicious circle of credit availability and economic activity seen in 2008 can now turn virtuous.

Aggregate estimated corporate profits in Europe have fallen by roughly half from their peak two years ago. Return on equity (including bank asset write-offs) has now returned to the single digit levels seen at the trough of the last economic cycle (including telecom asset write-offs). During the last quarterly reporting season (Q2) when most major economies were still in their worst post-war recessions, most European companies already reported better than expected profitability. What then should we expect to happen to profit expectations over the coming months with a “V-shaped” economic recovery on its way?

If we think that return on equity will get back to somewhere near its previous peak of 18% and that book value will grow significantly over the new economic cycle then should we not also expect aggregate corporate earnings to exceed the previous cyclical high of 2007? This would be more than 100% upside to corporate earnings from here, putting the peak market P/E ratio somewhere close to 5x rather than the current headline 14x. Making such arguments seems fanciful even ridiculous today, but not to contemplate how operational gearing might work if economic growth returns to normal levels would be more outrageous. Those who reject the existence of an economic and stock market cycle at the bottom of the market are just as dangerous as those who dismiss it in the good times. “This time it’s different” are still the four most dangerous words in investing.

If 2008 will be remembered for a momentous economic collapse, 2009 will be seen as the year of surprisingly strong recovery. Having risen 20% year to date, it has been a good year for equities, but could 2009 turn out to be a very good year indeed?

Barry Norris
Partner, Argonaut Capital