Sunday, August 30, 2009
Recovery surprises leave markets floating on air
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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Late August is a dangerous time to write about the stock market, ahead of the autumn storms. This time last year I might have remarked on the solid gains shares were showing during the holiday month, with the FTSE 100 up more than 300 points.

Then banking armageddon arrived, pushing the index down nearly 2,000 points over the next couple of months. Not every autumn has a global financial meltdown and, fingers-crossed, history will not repeat itself. And we should not get too hung up about the seasons.

As Mark Twain memorably put it: "October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February."

Economists are not necessarily best-qualified to tell you where the stock market is going. Nouriel Roubini, the New York University professor, has made his name in the credit crisis. A nice piece on Bloomberg last week, however, noted that if investors had followed his stock-market advice in recent months they would have missed out on the "rally of the century", with the S&P 500 up 52% in six months, and the MSCI world index up 58%, the biggest gain since it started life in 1970. The FTSE 100's rise is nearer to 40%, impressive but continuing its relative underperformance of recent years.

Roubini's downbeat view of the American economy and the stock market may yet be right but timing is everything.

Some fund managers, on the other hand, have what economists would regard as highly unusual views about the economy. Neil Woodford, head of investment at Invesco and one of Britain's top fund managers, said: "I do not see economic recovery happening in the next three to four years", and this informs his investment strategy.

That would imply the longest period of recession*/stagnation in Britain's modern history and, together with the downturn so far, would be twice as long as Britain's slump in the 1930s. Nothing is impossible but, given that recovery has almost certainly already begun, this is highly unlikely.

The Bank of England's latest forecasts, published this month, imply the UK economy will be more than 9% bigger in mid-2012 than now. I would have a small wager that its forecast will be closer to the outturn than no recovery at all.

Why have stock markets risen so strongly? It has been a two-stage process. The initial spurt from the dark days of early March came with a realisation that the world was not entering a second great depression (third if you count the end of the 19th century) and that not all banks would have to be nationalised. Markets were priced for disaster and decided this had been averted.

The second leg has been driven by good figures. "Economic data generally continue to be better than expected, which suggests that we are emerging from the longest and deepest recession [since the second world war]," says Bob Doll, chief equity investment officer at Black Rock.

The figures suggest growth will have turned positive in every G7 country, including Britain, this quarter. France, Germany and Japan are already there. Germany's Ifo measure of business confidence has soared, a reflection of the fact that export demand has turned the corner. China has led a turnround for the hard-hit Asian economies, acting as the region's locomotive. America's housing market, where the recession story began, is showing strength in both activity and prices.

Normally, economic recovery is tinged with a fear in the markets that the authorities will take action to dampen it down, notably with higher interest rates. However, central bankers made clear at their recent annual gathering at Jackson Hole, Wyoming, that this is not on their agenda. The markets have an unusually clear run.

In Britain, while figures last week showed a nasty 10.4% fall in second-quarter business investment, the credit crunch still biting hard on spending by firms, most of the figures have surprised on the upside.

House prices and housing activity are up, with Nationwide reporting a 1.6% rise in prices for this month, a fourth consecutive increase of 1% or more. Prices are up more than 6% from their February lows, suggesting the big correction happened last year. While there are caveats about the housing recovery, Michael Saunders of Citigroup points out that it has positive implications for consumer spending and the banks, and supports his view of a stronger UK recovery than the consensus expects.

Not so long ago it was fashionable to say that this recovery would have to be without the help of overindebted consumers, who would be forced to deleverage (reduce their borrowing) rather than spend. What is clear, however, is that they can do both.

Darren Winder, economist and strategist at Cazenove, calculates that as a result of sharply lower mortgage rates and to a lesser extent falling energy prices, the amount households have available for discretionary spending is up by a striking 20% this year. That is why the numbers for retail sales have been strong and it is why retailing shares in the UK have virtually doubled from their lows.

More importantly, the economy has turned sooner than firms expected. After an avalanche of earnings downgrades earlier in the year, this month has seen 100 upgrades. Even more than the macro numbers, this is what drives stock markets.

We should not read too much into share prices. One thing we have learnt during this crisis is that markets are skittish, and hugely influenced by confidence and mood. There are solid economic reasons why the stock market has risen, however. Cazenove, taking the bull by the horns, says there is still plenty of value in British shares and limited downside risks.

The key influences on markets will be surprises. On the plus side, markets have priced in a recovery, both in Britain and globally. On the minus side, that recovery is expected to be weaker than usual, because of the banking system's long period of convalescence, tight credit and a throbbing fiscal hangover that will require years of tax increases and public spending cuts.

Where the stock market goes depends on where the news comes in relation to these expectations. There is scope for disappointment so far the global economic turnround has been faster and stronger than investors feared and these things never proceed smoothly. But there is also the potential for positive surprises.

Economies may shrug off the effects of the recession more quickly than feared and companies, having taken decisive action to keep afloat during the crisis, may see their profits benefit disproportionately from the upturn. Subdued wages growth, which is what we have, is good for profits.

Whichever way share prices go, they do not start from very demanding levels, even after the recovery of the past six months. The FTSE 100 is 30% down on its December 1999 peak, and nobody expects it to get back there soon. Cazenove's estimate, based on trend earnings, is that the FTSE 100 is 15% undervalued relative to fundamentals.

One day it will get back to that 1999 peak, by which time central bankers will be worrying about asset price bubbles again.

PS: It has been a lonely job counting skips all these years so I was intrigued to get a release from a company called Erento, apparently Britain's fastest-growing online rental marketplace. It reports a 38% rise in demand for skips in July.

We skip followers are aware of the pitfalls of relying on one month's figures, and of the need to adjust for seasonal factors. It could be that instead of going on holiday this year, people have decided to clear out the loft or garage.

But the rise does appear to be genuine, and part of a trend. After the doldrums of winter and early spring, demand for skips rose 26% in May and by a similar amount in June. A green shoot in a yellow skip.

From the Sunday Times, August 30 2009