In uncertain environment, keep cash and be flexible

THE global investment outlook appears cloudy with reports coming in from different directions, pointing to the need for extreme vigilance and flexibility.

Of interest is a report in The Telegraph saying that Morgan Stanley has issued a “full house” buy alert on international stock markets for the first time since early 2009.

“The US investment bank said that all five of its market-timing signals are now flashing a buy signal as selling-fever reaches capitulation levels.

“This is a rare occurrence, typically leading to a V-shaped recovery that delivers a 23% gain in stock prices over the following 12 months,’’ wrote Ambrose Evans-Pritchard in The Telegraph.

Quoting Graham Secker, the bank’s chief European equity strategist, the report said the sell-off over recent weeks was largely driven by emotion and had little to do with the underlying outlook for the world economy.

“Equities remain very cheap relative to government bonds and there remains a lot of liquidity around that is looking for a home,” Secker was quoted as saying.

The report pointed out that the trailing dividend yield on stocks – measured by the MSCI Europe index – is currently 240 basis points above the yield on a mix of European government bonds, near its all time-highs over the past century. Such levels usually precede powerful equity rallies, the report added.

“Morgan Stanley’s bold call has raised eyebrows since the bank caught the exact top of the European equity market in June 2007 using the same timing indicators, on that occasion issuing a “full house” sell alert.

“It comes at a treacherous time for global investors as they try to fathom what is really happening in China and brace for the first rate rise in nine years by the US Federal Reserve, a move akin to a margin call for debtors in emerging markets with US$4.5 trillion of US dollar liabilities,’’ said Evans-Pritchard.

“Our indicator is not the Holy Grail of investing. We think that on the balance of probabilities, the risk-reward ratio looks pretty good right now, but it is not a very good week-to-week timing signal,” Secker was quoted as saying.

While certain quarters downplay fears over the global economic outlook, there are views that the current volatility in financial markets stems from a reaction to global imbalances which would take some time to clear up.

“The recent convulsions in global share markets are ‘just the beginning’ of a painful adjustment as money drains from emerging market economies,’’ David Dredge, chief co-investment officer of Fortress Convex Asia Fund, was reported as saying in the Sdyney Morning Herald (SMH).

According to Dredge, the current volatility in financial markets is in the early stage as markets react to a correction of global imbalances that will last from18 months to three years.

“The financial links to easy-money policies in the US have unleashed a burst of credit expansion in emerging markets that has proved unsustainable and is now in the process of unwinding.

“That is forcing a painful ‘market-induced tightening’ that will impact on the growth of emerging markets as credit expansion is halted and reverses,’’ said the SMH.

And just when the bulls on Wall Street think that the worst is behind them, JP Morgan is reported to have come up with a warning that a large pool of assets controlled by those programmatically trading equities regardless of underlying fundamentals, are about to start selling equities and are likely to negatively affect the US stockmarket in coming days and weeks, said an article in David Stockman’s Contra Corner.

These programme traders include price-insensitive managers such as derivatives hedgers, trend following strategies (CTAs), risk parity portfolios and volatility managed strategies.

“JP Morgan estimates that the combined selling of volatility target strategies, CTAs and risk parity portfolios could be US$150bil-$300bil over the next several weeks,’’ said the article.

Yet another word of caution comes from Nobel Prize-winning economist Robert Shiller from Yale University who sees the “risk of substantial declines” for the US stockmarket ahead, based on his research of historical stock market valuations, said CNBC.

Shiller measures valuation with his cyclically adjusted price-to-earnings (CAPE) ratio, which looks at price divided by 10-year average earnings.

“The CAPE ratio right now is around 25. It’s high,” Shiller was quoted as saying. The historic average is around 17, a level that would correspond with about 11,000 on the Dow and 1,300 on S&P 500. A retracement to those levels would represent more than 30% declines, said CNBC.

“The monthly CAPE ratio reached a peak of 44 in the year 2000 and that was followed by an important (market) drop. It went down to 13 and came back up to 27 in 2007 and it was followed by another drop,” Shiller was quoted as saying.

In such an uncertain environment, it is advisable to keep cash and be flexible, said Pong Teng Siew, head of research at Inter-Pacific Securities.

“It is not like the 2008 financial crisis when the banks were affected and payment systems halted. It is now focused on valuation issues of overpriced stocks across the board on the KL stockmarket except for the oil and gas sector where most of the excesses have been flushed off,’’ said Pong.

Six years of bull market is a long time; investors buy with a five-to-seven year timeframe and those that bought stocks last year had taken on a high risk, said Pong, adding that despite having started on the downtrend earlier than most Asian bourses, the KL stock market may still have a substantial leg downwards.

Stock and sector picking based on fundamentals and good value will be challenging in the coming weeks and months.

Right now, the belief seems to be that stocks may get cheaper and it would be wise to accumulate cash for the right moment to buy.

What is the bottom is anybody’s guess. As Pong says it is easy to call a “sell” but to call a “buy”; have we reached the bottom yet when the excesses are all around us, with some stocks trading at 40-50 times price-earnings ratios?

Columnist Yap Leng Kuen reckons stockpicking requires a lot of study, especially at stocks that have trimmed off a lot of fat.