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The surge of almost 13 per cent in the FTSE All Share Index in one week in late November was the biggest weekly rise in that index since December 1976 (when it rose close to 19 per cent). A month earlier the index had climbed just under 12 per cent in one week, and at the time of writing, it’s up over 9 per cent in the past week.
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These surges are happening at a time when some brokers are suggesting clients dip a toe in the most cyclical of cyclicals, retail stocks as well as other shares in other companies whose earnings are leveraged towards buoyant economic growth. After all, everyone knows that the early investor who jumps in to the bear market just before it turns makes the greatest rewards.
Figures must, of course, always be put in perspective. Even including these bounces, the FTSE has declined x per cent from its record high in June 2007. When stocks surged in the mid-70s the market was just coming out of a massive sell off, where it had lost something like two thirds of its value. Now could be the time to think about buying shares.
Unfortunately, it’s not as simple as just deciding to take the plunge and invest in the market. Your view of when the economic recovery will take place is crucial to which bets you make.
We agree that the bulls argument for investing in stocks that benefit from a recovery by the middle of 2010 is very enticing. Where there is carnage and companies fold, either by consolidation, or by going into administration, those that hang in there emerge stronger and more profitable when times are good. Retail is a classic example of this. At a time when retailers Woolworths and MFI have gone into administration and others are facing the poorest demand conditions they can remember, some stockbrokers are telling clients to buy. Panmure Gordon’s retail analyst Philip Dorgan thinks that the moment talk of recession dominates the public agenda, recovery is imminent, both for the sector and for investors. He is advising investors to buy Home Retail, Marks & Spencer, Ted Baker, Tesco and even JJB, which it appears to us, will be lucky to be operating for long after Christmas. Elsewhere, rival broker Investec has revived data from the last recession in the early 1990s, indicating that rallying in retail stocks occurs 18 months before economic growth, measured by the actual gross domestic product, started to rise. Investec likes apparel retailer Next.
There is however, a case to be made that these views are far too optimistic. That, much to Mr Brown’s chagrin, consumers will not miraculously resume the widespread profligacy seen throughout the past decade in 2010 benefiting retailers. This won’t happen in my opinion for one big reason: debt.
A big difference between this recession and prior ones is the leverage effect. And it can be seen at every level. Banks, the government and individuals have never been so indebted. Credit card and mortgage indebtedness has risen exponentially. In the past 10 years outstanding mortgage debt increased from £450bn to £1,200bn, while consumer indebtedness has risen from £100bn to more than £230bn, making the UK population the most highly indebted in Europe.
The government in Britain has concealed the full extent of its indebtedness, although the pre-Budget report indicates that its borrowing will rise from £78bn this year to £118bn next year. By 2013/14, the level of debt will hit 57 per cent of gross national product (GDP), higher even than in the 1970s, when the Callahan government had to call in the IMF to bail out Britain.
Finally, and most damning, is the issue of bank debt. Banks are literally the boiler room of the economy. In this case, if the boiler’s broke, the economy goes cold. Banks aren't lending to businesses, both big and small, in an effort to rebuild their balance sheets after the disastrous losses they've made making billions of pounds worth of write downs. Over the past 10 years peak levels of leverage at major domestic banks have climbed from close to 30 per cent to just over 60 per cent, according to the Bank of England.
So, as with everything, there is a case to be made for both scenarios: the goldilocks scenario being painted by our venerable prime minister, or a more bleak picture, subscribed to by high profile economists and strategists like Albert Edwards and James Montier at Societe Generale. Although it needs to be said that these two are the most consistently bearish investment bank strategists.
The Bull Portfolio
An optimist's viw of the market is that it will continue to rebound and assumes that stocks whose earnings growth is based on consumer spending will benefit the most. There was an element of short covering in the bounces, or buying by investors that had sold the company short in the expectation that they would profit by being able to buy it back at a lower price. But it wasn't an accident that many of the companies whose shares climbed the most were those that had also been clobbered the most. These companies are in sectors that were among the highest rated when times were good: banks, miners and retailers. If you believe in the bull scenario, these are the ones to own, at least initially (for six months or so).
We mentioned retail above, but the other two sectors deserve more attention. In the case of the miners, commodity bulls point to the longer-term story. A prolonged period of weak prices in the 1990s led to woeful under-investment in new capacity. Investment picked up again during the recent price boom, but as prices slide, expansion projects have once again been deferred and capital expenditure curtailed. Much more of the world's productive capacity is now in private, rather than state, ownership, so output is much more likely to be cut the moment it becomes unprofitable, rather than kept open to preserve jobs. This, bulls say, is just creating the next supply squeeze.
Also, the slowdown in China is, in our opinion, being rather over-played - just as its contribution on the upside was. We have yet to see any forecasters predicting gross domestic product growth of less than 8 per cent in China for next year - slower than last year, but still way in excess of western economies. Furthermore, while the US government throws trillions of dollars at failed banks, the Chinese are investing in infrastructure - the government said in early November that it would invest $586bn over the next 10 years.
A rally in financial shares is slightly more complicated, because of the government’s involvement. Hence we have recommended two in which the state’s shareholding is zero. These companies will definitely benefit from reduced competition. Also, in the case of insurance, there has never been a better time for that industry. Insurers are price-makers right now as nervousness pervades all areas of the economy.
It is also worth mentioning at this stage that we are not saying that these stocks will rally for the duration of the bull market. Our companies editor Simon Thompson is insistent that those companies that do the heavy lifting in one bull market will not be the power lifters in the following one.
HSBC
Forget about the bank's £1bn exposure to the Madoff hedge fund and you will see that HSBC has managed the credit crisis better than the bulk of its competitors. Early in December HSBC announced plans to make £15bn of loans to UK home owners in 2009, double the equivalent amount it lent last year, bucking the trend of banks pulling out of the shrinking mortgage market.
PRUDENTIAL
If you're optimistic about the world's growth prospects then Asia is the place to be which is why Prudential is a good bet. The insurer has a strong capital position and healthy businesses in the US, the UK and Asia. Based on the EC's insurance groups' directive, it had a capital surplus of £1.2bn at the end of September. Figures like this have put paid to rumours of an impending rights issue.
BHP BILLITON
BHP wouldn't be in this list if it had succeeded in its all-share bid for Rio Tinto. We are relieved that the whole business is over as it was over-ambitious at the very least, being pushed through at the peak of the cycle. The diversified miner is one of the lowest cost producers in the world. Its position as one of the dominant players in base metals, iron ore, manganese and coal puts it in prime position for any recovery.
ANTOFOGASTA
Our companies editor Simon Thompson says any bounce in the copper price is a predictor of the end of the bear market. In the past six months the copper price has fallen about 60 per cent to late 2004 levels, but bulls should watch it closely. Also, our favourite play in the mining sector is the Chile based copper miner Antofagasta, which also happens to have a cash pile of over $2bn, even after significant expansion.
NEXT
Next finance director David Keens admitted to us that the company is entering a tough period due to weaker consumer demand an pressure on margins. But in these conditions, it has the ability to capture market share, being able to provide credit where others cannot. The home shopping debtor book is financed by two long-term bonds with a face value of £550m. Mr Keens says that bad debts are relatively low due to shoppers’ fear of a poor credit rating.
The Bear Portfolio
Some bears would say the best thing investors can do now is hold cash and accept the bank’s deposit rates. Others would go further and say put your hard earned savings under the pillow.
We don’t subscribe to this view. If you are bearish, there will be a flight of funds towards the world’s virtual reserve currency, the US dollar. This is because the vast bulk of the world’s debt is priced in dollars and there is little chance of inflation any time soon, even if the US has its printers running 24/7.
Both the pharmaceutical and tobacco sectors earn the bulk of their profits in US dollars. This was an important consideration in choosing these companies, along with the obvious consistency of demand for their products. People will always get sick and enough people will always want a smoke.
Continuing to cut interest rates is no longer available as an option for the authorities, as it wasn’t for the Japanese in the early 1990s. You can only cut interest rates to zero, which is close to where the US official interest rates are currently and where Japan's were in the early 90s. The Japanese decision to flood the long end of the bond market and print cash is what the US authorities will probably do. With long-dated government bonds falling to artificially low levels of between 3 and 4 per cent, the yields of utilities of above 6 per cent look very attractive.
GLAXOSMITHKLINE
The pharmaceutical giant is somewhat cumbersome, certainly, but it has its finger in so much of the healthcare pie that there are few people in the world who have not been a customer at one time or another. Of the global pharmaceutical companies Glaxo is in a good positions to handle the current environment of expiring patents on existing drugs, as well as pricing pressure from generic competition.
ASTRAZENECA
AstraZeneca's thin pipeline of prospective drugs is a risk we think is worth taking when compared to its cash flow. The company’s sales increased 9 per cent in its second quarter to $7.96bn. Admittedly there were exchange rate benefits due to the stronger US dollar, but we continue to be confident about its growth in the medium term. Firstly there is the unbelievable amount of fat being cut out of its business model as it slims up to counter the tougher environment, and secondly there is the growth of 20 per cent plus it is achieving in emerging markets.
PENON
One of our favourite water utility plays is Penon because its financing is flush compared to its competitors. The company recently signed a further £100m facility with the European Investment Bank although finance director David Dupont has told us it will probably need a further £500m in facilities over the next five years, two thirds of which will come from existing facilities that can be rolled over, albeit at a higher cost.
BRITISH AMERICAN TOBACCO
The tobacco giant is not has defensive as it once was. Much of its growth is in emerging markets in Asia, South America and eastern Europe where it sells about half its cigarettes. But that growth engine is not going to stop any time soon, even in the current global slowdown. BAT's management was almost gungho in its bullishness at the third quarter results, but the resilience of the group's sales in difficult times cannot be underestimated.
DIAGEO
Diageo's financial strength is enabling it to take advantage of Pernod Ricard's weakness in the world's biggest spirits market, the US, where Diageo generates about 40 per cent of its £9bn annual turnover. As producer of premium labels like Johnnie Walker whisky and Smirnoff vodka, Diageo is proving to be the toast of the emerging middle classes in the giant Chinese economy.
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-IC-1.9.0c-prod - 15/05/2009 11:00:33 - stuart.turner
