In this space a year ago, I suggested that 2007 would be a year in which professional  investors needed to start dusting down their knowledge of how bull markets end.

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Given that the timing of market turns cannot be predicted with precision, that proved not to be such a bad suggestion. Although world equity markets limped to a single digit positive gain over the year as a whole, the bald statistics do little to conceal the drama that has been going on beneath the surface.

Any doubts about the likely severity and duration of the credit crunch have long since given way to a recognition that what we are witnessing is a full-blown banking crisis that can no longer be kept in an isolation unit, away from the general ward of the real economy. Just as few bull markets have prospered without the participation of banks, so it seems improbable that the current bull market, which has passed its fifth anniversary in the United States and fourth in Europe, can be sustained unless it includes in due course a revival in the banking sector.

Add to that the sharp rise in daily market volatility and a continued array of poor technical signals, and the real surprise has to be that the equity markets have until recently held up as well as they have in the face of adverse sentiment, consumer jitters and bond market angst. It seems increasingly clear that the real decoupling that is taking place is not that between emerging markets and the US economy so much as that between investor behaviour and reality. After months of struggle, it seems that the bears are moving into the ascendancy.

When markets wobble, experience in investment invariably counts for more than raw but youthful enthusiasm. If there are many long-serving fund managers who are not privately cautious about short term prospects in 2008, they are keeping remarkably quiet about it. According to Anthony Bolton, Fidelity’s star professional investment manager in London, “We are in the middle of a full-blown banking crisis. No one yet knows the full contagion effects in debt markets.”

Over the course of his 27-year career as a full-time fund manager, Mr Bolton has outperformed his benchmark, the FTSE All-Share index, by a remarkable 6% per annum, easily the biggest margin of outperformance in his peer group. Although not given to idle market forecasts, it seems clear that he expects the equity market to be weak, volatile and angst-ridden in the first half of 2008 (which therefore, one suspects, he sees as not a bad moment to be bowing out of day to day investment decisions).

Needless to say, public hopes and private fears are not always one and the same thing. One reputable trade association survey of fund managers and financial advisers at New Year reported that 77% of IFAs and 61% of fund managers were confident that world markets would rise in 2008. The main difference between the two groups was that the fund managers favoured large cap stocks and Asia Pacific as the likely best performers, while the financial advisers – true as ever to the maxim that from a sales perspective it pays to pick whatever sector or region did best in the year just gone - think it will be resources and emerging markets.

On past form such surveys are more of a contrarian than a positive indicator, and one that advocates of the themes of commodity supercycle and emerging market decoupling will no doubt wish to ponder, compelling though the longer term outlook for both stories remains. The more encouraging news is that the savagery of the downturn in some market sectors in the last few months is now clearly creating value opportunities in certain areas. In his presentation to the annual meeting of one of his funds, Mr Bolton reviewed relative valuations over the course of his career and highlighted some well-known but interesting anomalies that have stubbornly failed to be rectified in that time.

So for example from a secular perspective quality stocks, as measured by the relative valuations of companies with different credit ratings, have never been so undervalued at they are at present. Despite a recent reversal in a long-running secular trend, large cap stocks still look very cheap relative to their midcap cousins. Banks collectively are now trading on relative valuations that are every bit as poor as at any time in Mr Bolton’s long career. He has recently started to take a tentative position in some bank stocks, while continuing to hold an above market weighting in the media sector.

The broader conclusion appears to be that, whether or not beta produces a negative return in 2008, which looks increasingly unlikely, the next 12 months will produce some outstanding opportunities for stockpickers to add value for the medium term.  That won’t help marketing departments or cash flow, but it may yet be the best that fund managers can hope for.  Their optimism in the surveys looks more than a little like whistling to keep themselves cheerful. The payoff when the cycle resumes may well be impressive however.
 


Jonathan Davis
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