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When liquidity goes, fundamentals endure

When liquidity goes, fundamentals endure
November 7, 2018
When liquidity goes, fundamentals endure

Perhaps there is a tendency to downplay (or even ignore) the poor decisions made by a company until they’re exposed by a sustained market correction, a phenomenon my colleague James Norrington might put down to cognitive dissonance. But it’s not difficult to appreciate why investors have been willing to hold fast to a rising balloon over the past few years.

As a rule of thumb, you can expect equity market indices to oscillate by 10 per cent or more every other year, but average volatility rates have been relatively subdued since the global financial crisis, a possible reflection of the amount of liquidity that central banks have been pumping into markets. If investors feel that the government is effectively back-stopping their positions, they will be more inclined to buy on temporary market weakness, which supports valuations over the long haul.

The S&P 500 was becalmed through 2017, registering its lowest volatility rate in decades, but things have been far more febrile this year. We witnessed a spike in the CBOE Volatility Index (Vix) in February, along with an accompanying sell-off, although valuations retraced in short order. But turbulence returned to markets with a bang last month, triggered by a long-expected tech stocks rout. Even though history shows that October is a relatively volatile month anyway, the rise in the Vix means that 2018 is shaping up to be the most volatile year in a decade.

Market oscillations in the UK haven’t been quite so pronounced as those across the Atlantic, but most would argue that domestic equity valuations aren’t quite as stretched. However, if we are indeed witnessing a turn to an ebb tide, you would imagine this would be reflected in the frequency of profit warnings, particularly given the optimistic earnings outlook built into many equity prices. And there seems to have been no shortage of late.

Bookie William Hill (WMH) has just warned over full-year earnings as regulatory and tax changes hit online growth, while the going remains tough for its high-street betting shops, presumably as punters come to the realisation that the only way you can make money following horses is with a shovel. Other recent profit warnings seem to support the view that the next recession in the economy will be consumer-driven. Warpaint London (W7L), a supplier of budget cosmetics to high-street chains such as Boots and Superdrug, as well as department stores Debenhams (DEB) and House of Fraser, is now struggling in the face of sagging demand, with customers reducing stock levels and Christmas orders. Those warnings came on top of a negative update from UK fashion label Superdry (SDRY) and further bad news from Debenhams itself.

The pressure on discretionary spending is also reflected in EY’s Profit Warnings Console, which points to a seven-year high in general retailers’ profit warnings through the third quarter of 2018. It means that a third of sector constituents have issued warnings over the past 12 months. The EY analysis shows the median share price fall on the day of the Q3 warnings at 21.2 per cent – the most severe markdown since the height of the global financial crisis, although that is probably a reflection of the lofty valuations on offer. Nevertheless, the pressure on household budgets – and faltering consumer confidence – is evident in the FTSE Travel & Leisure sector, where a quarter of the representative companies have also issued warnings over the same period.