"Market efficiency is a description of how prices in competitive markets respond to new information. In fact, the arrival of new information to a competitive market can be likened to the arrival of a lamb chop to a school of flesh-eating piranha, where investors are - plausibly enough - the piranha. The instant the lamb chop (information) hits the water, there is turmoil as the fish devour the meat... as investors buy and sell securities in response to the news, causing prices to change. Once prices adjust, all that is left of the information is the worthless bone."
The problem I have is that I feel there is ample scope for several lamp chops, and pretty unsavoury ones at that, to surface in the financial markets in the months ahead. Now, that would not be a problem if valuations were already discounting, to a degree, these potential risks. However, they are not.
For example, in the past 12 months, the FTSE 250 index has rallied by over 40 per cent to its all-time high last month, while in Europe the Dax 30 has run up an incredible 53 per cent. To put this into perspective, the UK mid-cap index looks priced for perfection, trading on 17 times earnings estimates - and that's after factoring in 7 per cent earnings growth this year. Or, to look it another way, the prospective earnings yield (the reciprocal of the PE ratio) is 5.8 per cent, which hardly compares favourably with risk-free government 10-year bond yields of 5.53 per cent. By comparison, at the start of this year, the mid-cap sector was trading on a more realistic 14.5 times earnings estimates, giving an earnings yield of 6.9 per cent, which did compare favourably with UK 10-year bond yields of around 5 per cent.
So, in effect, we have seen a steep rerating of the mid-cap sector during a period when bond prices have been rising markedly. This raises three concerns.
First, mid-caps, which are stuffed full of interest rate-sensitive sectors - such as housebuilding, real estate, support services, travel, leisure, personal and household goods - look vulnerable to further monetary tightening. These companies have benefited greatly from an era of ultra cheap money, but that era has abruptly come to an end. What's more, it now seems inevitable that, following news that the Monetary Policy Committee (MPC) voted by the wafer thin margin of five to four against a rate rise this month, base rate will be belatedly raised next week as the hawkish governor Mervyn King garners support of the doves. If City economists are to be believed, this is unlikely to be the last base rate rise this year, either. We could therefore be in a sustained period of monetary tightening when both short-term interest rates (set by the MPC) and long bond yields (set by the market) are simultaneously increasing. A consequence of this is that if bond investors take fright, sending long bond yields even higher - and they are already jittery - then the mid-caps, whose valuations have been propped up by the wave of merger and acquisition activity fuelled on cheap credit, are the most vulnerable to a derating.
Second, the oil price has been rising all year with Brent Crude increasing from around $50 a barrel in January to over $70 a barrel now. If the oil price were to stay at this level, and Opec has reiterated its commitment not to raise production quotas, then at the very least this is storing up an inflation problem down the line that will have to be addressed. So far, equity investors have adjusted well to higher oil prices, but any spikes in the months ahead - be it due to geopolitical tensions or a natural disaster (we will shortly be entering the North American hurricane season) - has the potential to send further jitters into the equity markets.
Third, investor sentiment has been very bullish for a long time with all asset classes - property, commodities and equities - rising simultaneously, driven by a global monetary system awash with cheap money. Indeed, UK money supply rose at a heady and unsustainable rate of 13.8 per cent in the 12 months to end May. In my view, a period of monetary tightening will be the reality check that dents this sentiment.
Therefore, it makes sense to take out some sort of portfolio insurance against any of these bearish scenarios materialising. The product I have in mind is an SG Securities listed short contract for difference (CFD), C360, on the FTSE 250 index. It has a guaranteed stop-loss of 13500, a stop-loss of 13100 and expires on 12 October 2007. So, with the mid-cap index trading at 11600, our CFDs have 1900 points of intrinsic value. However, the price of the CFD - 2,045p-2,048p on the bid-offer spread - is a bit higher, reflecting the fact that, as we are shorting the index, we have to factor in the payment of dividends. In other words, I need the index to fall from its current level of 11600 to 11452 at expiry to break-even. But if I am right, and we are indeed in for some turbulent months ahead, then this is a low-risk way of protecting our portfolios. For example, if the FTSE 250 index fell 5 per cent to 11000 by mid-October - which looks a realistic possibility and is my immediate target price - my CFD would be cash settled at 2,500p, producing a 22 per cent gain.
