Ideas Farm: Where's the bottom?

Are we witnessing a capitulation in the stock market?

The sell-off in equities so far in 2022 has not been as fast or brutal as the one which greeted the pandemic’s onset. But neither has it been pleasant. Any investor with big exposures to world share indices or the S&P 500 will have seen most of 2021’s gains evaporate.

In fact, strip out those brief few weeks of freefall in early 2020, and times haven’t been as bad since the financial crisis. For investors, Covid-19 inflicted a sharp but temporary blow. In 2022, they are getting used to a market of a thousand cuts and entrenching pessimism.

Things may be getting worse. Fast rising interest rates and falling growth expectations have badly wounded markets’ ability to sensibly value assets – or put a price on just about anything.

Hence, possible capitulation, and acute stress all round.

‘FOHO’ – the fear of holding on – will be very real for many investors right now, particularly for those who have never experienced a major drawdown. In such moments, an understandable urge is to look for market parallels to guard against what might come next.

One such parallel is the 2007-09 crash, when equity markets steadily leached value over two years and the global economy adjusted to a total collapse in credit. From peak to trough, the MSCI World Index cratered 41 per cent.

While today’s credit conditions are also tightening rapidly, comparisons with the financial crisis shouldn’t be overdone. The 2007-09 sell-off occurred with the global banking system on the precipice. In 2022, large-scale institutional collapses are not on the menu in developed markets.

What about the dotcom crash? While allowing for one critical difference – in that many of today’s largest and most hyped technology companies are at least profitable – the equity market descent between 2000 and 2003 has echoes of our current downward revision in valuations. But like the financial crisis, it was a period marked by falling, rather than rising, interest rates.

Might cryptocurrency markets offer insight? Last weekend, the price of bitcoin sank below $20,000, and to a point at which some major leveraged positions reportedly face margin calls. Crypto evangelists and doubters watched for signs that forced liquidations could push down prices lower still. But that didn’t happen. Instead, bitcoin has bounced a fifth off its lows.

However, anyone hoping this might prove the canary in the risk asset coal mine should note that bitcoin’s price is tied to little more than speculation (and according to a 2017 study, frequent market manipulation). Share prices, by contrast, represent something tangible: the discounted value of a company’s expected future cash flows.

So if parallels offer limited comfort, what is an investor to do? One approach, advocated by investor Sir John Templeton, is to keep a wish list of previously expensive quality companies that might soon start to look cheap.

Another is to go bargain hunting. Across all LSE-listed equities, the proportion of shares trading at a discount to book value has rocketed in the past year – from 20 to 38 per cent of all stocks with a one-year trading history and more than £100mn in market value.

As you might expect, the ratio is higher among smaller companies and trusts. Some will be cheap for a reason, but all have a high bar to clear: at current levels of inflation, companies need to earn a double-digit return on assets just to preserve capital values, all while the economy starts to contract.

But we can add an extra layer of protection: stocks priced at a discount to book value, with a net cash or cash reserve position. According to FactSet, 71 UK stocks have such a buffer.

Then again, with UK inflation at 9.1 per cent, is cash really a virtue right now? Or a wasting asset? Markets offer few easy answers.