The State of the Market01 October 2008

The big questions today are whether we have hit the bottom of the stock market train wreck, and if so, when will the market recover? A simple answer is not forthcoming. We have an unusual set of events that have coincided in a unique way making it impossible to draw on past history for lessons, and leaving the experts somewhat dumb-founded in their ability to confidently predict the future. The stock market has endured highs and lows, booms and busts, bubbles and bursts for around 200 years now. History tells us that the market will recover - it always does. We have sufficient data to confidently demonstrate that stocks beat bonds and many other investment assets over long horizons. More specifically, if we carve up the last 100-plus years into 10-year intervals, stocks have invariably beat bonds in these sub-periods. While there have been some periods when stocks have delivered lower returns, and indeed occasionally negative returns, for an investor with a horizon of around 10 years, a long-term position in the equity market is unlikely to go too far backwards. A further line of support for maintaining a position in stocks concerns the excellent dividend yield that Australian firms offer. Combined with the dividend imputation tax credit, Aussie franked dividends offer a very competitive yield compared to their overseas counterparts; and to date there have been no systematic reductions in payouts. Hence, for a long-term investor, the dividend stream can be compared favourably to a coupon stream from fixed interest, and the regular cash inflow arguably dulls the pain of the current capital losses. The challenge is whether to buy now, as indeed many in the market are championing the prospect of over-reaction. That is, some analysts are arguing that the market has moved too far and that current prices are low compared to fundamentals of the underlying businesses. Take the resources sector for example where the commodities boom is riding off the back of huge increases in demand from places such as India and China. Economic growth in both of those economies will sustain strong demand for commodities such as coal and iron ore for several years to come. Consequently, it is argued that the recent falls in BHPB and Rio Tinto are an over-reaction to the general financial conditions. Similarly, the Aussie banks have been marked down despite the calls from those supposedly with the inside knowledge that our banks are fundamentally sound. If you buy the above arguments, then now looks a good a time as any over recent years to enter the market. Certainly by historical standards, forward P/E multiples appear on the low side. But remember that P/Es can move upwards either through price gains or falls in earnings. It is really this latter issue that is hard to resolve. The market has been hoping that the write-offs and revaluations that have hit the corporate accounts are now over. However, the trickle (or is it really a gush?) of bad news flows every day. So the question remains as to where corporate earnings are headed. Putting aside the emotive arguments over greed, the root of the today's problem is one of valuation. Many of the exotic debt structures have involved instruments that are not truly marked-to-market. This is despite some commentators blaming the accounting requirements to value at market as causing the problem. The difficulty is, unlike shares, an investor cannot look up a current price for these instruments and be confident that there are buyers and sellers willing to transact at that price. As a result, no one is really sure of the value of the balance sheets. The problem becomes compounded because many of these leveraged structures are inter-linked meaning that their valuations are dependent on other valuations. And there is a clear absence of incentives to realise the valuations. Thus, banks and other financial institutions are unwilling to engage in transactions for fear of realising losses or fear of transacting at prices that do not accurately reflect true worth. Consequently the costs of doing business have escalated as those remaining in the market pay premiums for the uncertainty. So, to the US Treasury's current dilemma. The Congress-defeated bail-out plan was really a taxpayer buy-in to Wall Street. The plan was for the government to buy the problematic securities and take them out of the market. However, if the market cannot get the valuations right, then how can the government be expected to do so? In part, Congress was concerned that the government would probably over-value at the margin simply to achieve its aim restoring some calm. This plan may have alleviated the current crisis in the short-term, but the challenge is how to shore up the fall in housing prices. If house prices continue to tumble, then more of the debt becomes problematic and thus it follows that further pressure is placed on balance sheets of financial institutions. Where to from here? Much can happen in a day, let alone a week. Unlike many of previous major episodes of economic strife, the current crisis has originated in financial markets and has yet to really impact on the real economy. There are signs in the US that this contagion is not too far away, if it has not already hit, but Australia is looking solid. However the reality is that as money gets tighter every day, even sound business models need access to capital, and unless they have sufficient cash reserves they will be forced to pay higher funding costs as loan capital rolls over. This will inevitably mean that good businesses will find it increasingly difficult to fund their operations. There are a few certainties going forward. First, the markets will be volatile and any investor should be prepared for a rough ride. It is likely that the news will get worse before it gets better but have the markets already factored this into current prices? In the coming weeks, expect some chaotic price movements as the US banks try and settle their annual accounts during October. Second, governments will intervene in an attempt to restore some stability. But will their actions weaken longer term conditions? Third, central banks will look to monetary policy as a mechanism to stimulate demand. That is, expect interest rate cuts going forward, with the Australian Reserve Bank Board sure to cut the cash rate during October. But will their decisions be able to cross the divide between the financial markets and the real economy? Finally, there will be investors who make significant gains out of the current market. They will buy distressed stocks based on sound balance sheets, strong cash flows, and a strong management team with a sustainable business model. Liquidity will be a challenge as some good value will be found among smaller capitalised stocks but the market is extremely thin at the small end of the bourse. However, the alternative of a traditional index approach ensures a nervous period given the heightened level of volatility. The winners will be those that have the fundamental investment skills who ignore the market rumours, and pay attention to the basics. Now, more than ever, the stock market is no game for naive investors or those who are captured by the marketing gloss of fund managers seeking to restore their assets under management (and consequently their fees). Tim Brailsford Frank Finn Professor of Finance Head of School UQ Business School