KEY POINTS:
The world stockmarket has fallen by 46.8 per cent, in US dollar terms, in the past 12 months. The New Zealand stockmarket isn't much better - down 33 per cent.
Such large falls are extraordinary, historic and particularly unnerving for people who have recently committed their savings to a balanced retirement portfolio. For example, a portfolio of bonds, property and shares put together 12 months ago will be on average down by about 15.6 per cent.
That's 15.6 per cent of someone's savings gone, and we are assuming there was no exposure to finance company debentures or CDOs. We need to go back to January 2006 to find a balanced portfolio that breaks even at current prices. Scary stuff.
What does it mean? What should we do? The sort of volatility we are experiencing galvanises historians and market strategists to recap the experience of earlier, similar crises. So let's have a look at some of these for guidance, especially looking for an answer to that most basic of questions - do we buy or sell?
The question in front of the panel is thus: whether the stockmarkets' drop accurately reflects, or under or over anticipates, an imminent decline in profits due to a slowing economy and higher interest rates? This in turn depends on your view as to whether the sharemarket is any good at anticipating the future - known as the efficient market hypothesis.
Recent evidence is not encouraging: a number of impossible things have happened in the past couple of months - as James Grant points out in Grant's Interest Rate Observer: "In the ninth month of 2008 occurred the biggest American bank failure, the collapse of the stand-alone broker-dealer business model, the bankruptcy of Lehman Brothers, the virtual nationalisation of Fannie Mae and Freddie Mac, the quasi-virtual nationalisation of AIG, the enactment of a plan to spend up to US$700 billion ($1.2 trillion) on orphaned bank assets and, on the next to the last day of the month that wouldn't seem to end, the biggest absolute point drop in the Dow Jones Industrial Average followed within weeks by the biggest absolute point advance in the Dow Jones Industrial Average."
Faced with this sort of behaviour it is hard to argue that the financial markets know what they are doing. The stakes, however, are high.
If you bought in straight after the crash of 1929, you would then be on the slippery slope and have seen a further 80 per cent of your savings wiped out before the markets bottomed. However, if you bought in after the crash of '87, you would have made 50 per cent within two years.
In the "markets are cheap" team we present evidence from London's Financial Times which reports that much of the selling of equities has come from leveraged investors - particularly hedge funds - rushing to sell anything they can to pay back debt and shift into cash. The pressure is particularly on shares because you can't sell property and you can't sell structured products.
The FT quotes Morgan Stanley as estimating that as much as US$1000 billion of the hedge funds industry's US$2000 billion could be withdrawn by early next year.
Buying shares with borrowed money isn't popular in New Zealand but a few years back Australian financial pages and finance websites were full of adverts for margin trading.
The mad rush for the exit also raises the question of the suitability of open-ended funds in extreme market conditions. Closed-end funds seem eminently safer for long-term investors than the typical managed fund or hedge fund.
Next up is Andrew Smithers from independent London-based economics consulting group Smithers and Co. Smithers doesn't own a fund management group, a stockbroker or investment bank so he's relatively independent and he has been bearish on world stockmarkets for as long as I can remember.
He uses two tools to value the market: q, which is the ratio of a company's share price to its net worth measured by way of replacement cost; and CAPE, the cyclically adjusted price earnings ratio which is the ratio of a company's price to the average of its earnings over 10 years.
In a paper dated October 13 he notes that stock markets have at last fallen to "fair value" but, before we get too excited, he adds that "in troubled times markets usually become cheap. A fall to 50 per cent underpriced would be quite usual by past bear markets' standards".
As supporting evidence Smithers provides a table which illustrates that, while the market is around fair value presently, at the bottom of previous bear markets in 1920, 1933, 1942, 1949, 1974 and 1982 the market has averaged 52 per cent undervalued on the basis of q and 50 per cent undervalued on the basis of the cyclically adjusted PE ratio. So that looks like a "sell" recommendation from Smithers.
While Smithers argues that markets could dramatically undershoot fair value, Tim Bond, global markets strategist for Barclays Capital, has looked at 11 past comparable financial crises to gauge the likely scale and duration of the impact on profits and thus stock market prices. He notes that the world is now moving on from the financial to the economic part of the crisis. His analysis suggests that:
* Economies will contract sharply and we should expect a recession more severe than those recently.
* Economic weakness will last for one to one-and-a-half years.
* Interest rates and inflation will fall.
* Based on the historic average decline, corporate profits are likely to fall by about 38 per cent.
* The equity bear market thus far is in line with both the historical average decline in equity prices and the average decline in profits. Since the inflexion point in most of the crises examined tended to occur just after the peak in government interventions, where this factor was relevant, we tend to believe that we have seen the worst of the equity bear for this crisis. That sounds like a "buy" call from Bond.
To confuse matters further Warren Buffett, arguably the world's most successful share investor, recently announced that he didn't know whether the markets had bottomed or not but he was shifting all of his own savings from Government bonds to shares.
A plunge in share prices is no fun but it can be considerably less painful if you have safe bonds comprising 30 per cent or so of your portfolio.
At these stressful times it is also worth considering different strategies for share investment and their implications for risk: when you own one stock and it falls sharply it's easy to construe possibilities as to why it has plunged and so you can quite easily rationalise selling.
Owning the whole market via a managed fund or index fund has the advantage that everything can't go bust so it is easier to hang in there.
* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.
