BT: Slowing growth, stretched markets, sharp sell-offs: are these signs of the end of the bull or has anything really changed? (14 Feb 2007)

MONEY MATTERS
And now, the good news

Slowing growth, stretched markets, sharp sell-offs: are these signs of the end of the bull or has anything really changed?

By LIM SAY BOON

GLOBAL equity markets are hinting at a possible correction. But the fundamentals underpinning the four-year international stock rally remain sound, and any near-term downturn is more likely to turn out to be a buying opportunity than a signal that heralds the end of the bull market.

The US, European, Japanese and a few key emerging markets are looking 'stretched' in technical terms. Many of these markets have been grinding sideways in recent weeks and divergences between price and momentum are betraying signs of underlying weakness.

Admittedly, the danger signals are not yet uniform across all - or even the majority of - global markets, with patches of strength still evident in some emerging markets. And besides, bearish divergences can be reversed. But sharp downturns in China in recent weeks and a sharp sell-off in industrial metals - ostensibly in response to rumoured problems at a commodities hedge fund - may be warnings of impending spikes in volatility and downturns in asset prices.

Keep your nerves if such a pull-back hits. Indeed, those who have yet to get into the market should consider the fundamentals - none of it would have changed.

For a start, serious wealth builders should look beyond the blips that will appear minor over a longer period of time and consider whether 2003 was the start of another long period of prosperity such as that seen from 1993 to the bursting of the tech bubble in 2000.

Consider the accompanying graphic showing an overlay of the S&P500 from 1993 to 2000 against the same index from 2003 until now. If history repeats itself, there are many good years ahead before the bear takes its turn to rule.

Sure, it would be infantile to simply assume that history will repeat itself. But note the relationship between the Fed funds rate and the S&P500. Note how, around the time of the LTCM hedge fund blow-up, the Fed cut rates and took the S&P500 to new highs. The cynics reckoned the Fed was creating another bubble to deal with the bursting of a hedge fund bubble. The optimist might have called it effective economic/financial management. Call it what you like - it still meant more years of rising asset prices.

Fast-forward to 2007, with US housing prices continuing to ease, there is good reason to expect the Fed to cut interest rates later this year to buffer the impact on consumers and the economy. Factor in the three 25 basis-point cuts that many in the market are expecting, and you can see one reason why history may just repeat itself again for US equities.

Another factor that supports continued buoyant equity prices globally is the amount of liquidity flooding financial markets. Despite the relentless disinflation in consumer prices worldwide over the past 20 years - smoothing the way for lower interest rates - liquidity has actually been surging. G7 broad money relative to nominal GDP has been rising relentlessly since the late-1990s.

Then there is valuation. Notwithstanding the spectacular gains in stock prices almost everywhere in the world, price-to-earnings ratios have not gone anywhere. That is, rising stock prices have been matched by equivalent gains in earnings per share.

In the US, the PE average has trended sideways in the past four years, around the mid-teens compared with the low to mid-20s at the peak of the tech bubble. In Europe, the PE average has similarly trended sideways in the low teens against 20-plus times in year 2000. And while emerging market PE ratios have risen from a high single-digit average in 2003 to the low teens now, they are still mid-cycle compared with the average of around 20 times at the peak in the late 1990s.

The view on valuations

Additionally, valuations in terms of equity earnings yields relative to bond yields, and returns on equity (ROE) versus short-term rates, make particularly interesting reading. Historically, long-term average bond yields have exceeded equity earnings yields. But right now the reverse is true. Thanks to historically low bond yields everywhere, equity yields now exceed bond yields. And thanks to the excess liquidity mentioned above, there is as yet no indication that bond yields will move permanently higher, notwithstanding the complaints about 'abnormally' low yields and murmurings of a 'mis-pricing of risk'.

So any reversion back to historical average on the so-called yield gap is likely to come through lower earnings yields. And while the rate of growth of earnings may be slowing in the US, earnings growth is still positive to the tune of some 9 per cent at the last count. So the 'leveller' is more likely to be yet higher stock prices.

Similarly, ROE in most markets is way in excess of short-term rates, thanks to the same excess liquidity factor. In particular, returns on equity far exceed short-term rates in the booming emerging markets - making their equities particularly attractive, especially as growth is already slowing in the US.

In the near term

Back to the near-term outlook. The US markets - from the S&P500 to Nasdaq - have been grinding sideways, with prices and momentum diverging. Ditto for the DJ Euro Stoxx 50. The Nikkei on the other side of the Pacific, having performed impressively in recent months, has run smack into a long-term downtrend line extending back to the early 1990s.

India, with its reasonably pricey 20 times prospective PE ratio and rising interest rates, is also vulnerable to a correction. China, having done a vertical ascent in recent months, was pretty much due for a correction - nothing surprising there.

Elsewhere in the financial markets, industrial metals have performed poorly of late and are likely to fare even worse in coming months. Oil, having range-traded back up to US$60 a barrel, could - in the absence of geopolitical shocks - head back down towards US$50 pretty quickly. And the US dollar, having staged a minor rally late last year and early this year, looks as if it is losing steam again.

What do all these developments have in common? Slowing growth. We could hear more about US housing slowing further, after a brief rebound late last year. Traders could talk about slowing US earnings growth. China's downturn could spread to India when the possibility of more rate increases in India bites the equity markets there.

But keep your eyes on the bigger picture - the cheap money, the excess liquidity, and the still generally modest valuations.

Lim Say Boon is chief investment strategist, group wealth management, Standard Chartered Bank.

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