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Beyond the sub-prime crisis

Monday 30 July 2007 02:57PM

Nobody could say that they weren't warned that this could happen. A repricing of risk has been inevitable at some point, given the reckless willingness of investors over the past few years to suspend traditional constraints that bind prices to intrinsic values across a whole range of asset classes, including exotica.

I continue to think however that the markets will recover from this latest panic attack once it has run its course, which may however not be immediately. What cannot be denied is that the consequences of fallout from the sub-prime mortgage problem will inflict some painful short term losses on investors in the worst affected assets.

According to Ben Bernanke, the chairman of the Federal Reserve, potential losses on sub-prime mortgages are in the region of $100 billion. That sounds like a lot, but in the context of overall borrowing in the United States, it is not that big a deal, if only the losses could be contained there.

However, as Ian Rushbrook pointed out at the AGM of the Personal Assets trust the other day, the multiplier effect of any losses in the sub-prime market could magnify the impact at least 10-12 times over. Rushbrook's AGM comments can be read in the Market Comment section of this site.

In addition of course, there is ample evidence that a genuine credit crunch of the kind that we may now be approaching can do a lot of economic damage, which in turn will send ripples through all currency, bond and stock markets. Last week we saw those ripples emerging in all three areas - the dollar strengthening, bond yields falling and stock markets taking a big hit.

Last week's fall of  4%-5% in global stock markets has already been enough to turn the technical signals from Investors Intelligence that I mentioned last time from bullish to bearish. As we have not had an old-fashioned correction in the stock market (defined as a fall of more than 10%) for four years, the chances that the past week's setback is the end of the downward move are not good. 

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Howver there is no reason to be unduly alarmed by the fact that the panic attack has hit now rather than later. There is a lot of common sense in the views expressed today by Anatole Kaletsky in The Times and by Gavyn Davies in The Independent. In particular, the former's argument that the current market wobble could well be the trigger that finally launches the fundamental style shift in the stock market that many of us have been expecting for some time seems very plausible.

If the credit game has finally reached its peak, Kaletsky argues, then from now on the mania for buyout deals financed by cheap debt will gradually lose its force, with a shift away from midcap "whisper stocks" towards large cap equities with strong growth and robust balance sheets. 

"The withdrawal of excess liquidity" he concludes "will cause a big shift in relative prices within the equity markets and big losses for investors in poorly structured leveraged deals. But this need not be bearish for equity averages and could be very positive for high-quality companies and markets, which have been left behind by the fads for issuing junk bonds". 

Gavyn Davies, formerly of Goldman Sachs, and now a founding partner of Fulcrum Partners, says in his column in The Independent that " a correction in risky assets has been long predicted by market pessimists, and indeed long-desired by many central bankers, who have been arguing that the risk appetitite of investors has become excessive and dangerous".

This is certainly true (and something I have argued in past columns), but need not "on its own spell the end of a global bull market". With so much unsyndicated debt still sitting on banks' books, they are bound to remain cautious until they can park it, which in turn won't happen until frightened investors have got over their panic.

This could take some time, and it could get worse before it gets better, Davies concludes. His final words of advice: "Watch the central banks, expeically in the emerging world, When their behaviour, not just their langugage, turns hawkish. the party will be finally over. Until then, probably not".

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In the meantime, anyone still wondering how we got from where we were to where we are now could do worse than read the masterly demolition job on the excesses in private equity carried out by the partners of Tweedy Browne, the old-fashioned US value investment firm that (among other things) was instrumental in bringing Conrad Black to judgement.

Or again they could look at the latest of Jeremy Grantham's always entertaining letters to investors. The latest one which first appeared days before last week's events, heaps more obloquy on the private equity industry and says that the market outlook is now worse than he can remember (which is saying something!).

While it reminds him of "nothing so much as watching a very slow motion train wreck", ironically he suggests that the markets are not likely to break finally until 2008, if only because of the Presidential cycle (Year 3 almost invariably strong for the stock market). 

Come the new Administration in October 2008, however, "a new administration with its new broom and new taxes and new antipathy to the financial world's rich, coupled with tighter credit and credit problems, we will have a very typical time, based on history, to have a bear market and I for one am betting on it".

In his latest market commentary, Sebastian Lyon, the CEO of Troy Asset Management, the fund management company established to look after the money of the Weinstock family, makes the point that cash is still yielding more than high grade bonds. in fact cash is yielding more than at any point in the past six years.

One consequence is that diversification is producing less compelling results than it has done in the past. The main asset classes are more correlated than they were in the past. In market conditions such as these, therefore, there is no need to be ashamed of holding cash, an argument that Jeremy Grantham has also been making all year. 

The market panic is meanwhile having its predictable effect on valuations. My latest screen of the FTSE 100 index on Company Refs produces 16 leading shares that are now on a prospective dividend yield of 5% or more, and 34 that yield more than 4%. The number of companies with prospective p/es below 10 has risen to 16 and nearly half the shares in the FTSE 100 are trading on a price to cash multiple of more than 10.

Do those figures suggest that there is value still in the stock market?  Yes it does. Every market fall creates opportunities for those who are prepared to back values rather than sentiment, and this one will surely prove to be no exception once the initial panic has worked its way through the markets. Market leadership will be different however.

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A similar story emerges from the investment trust market, where not only are discounts generally comtinuing to widen, but an unprecedented number of trusts are selling at discounts which are greater than those that the boards have publicly commmitted to defend through buybacks and so on. Widening discounts that cannot be easily explained are a useful forward indicator of forthcoming market weakness, as they have proved to be in the last few weeks.

But they are also a signal that potential buying opportunities may soon be coming along. When something as boring as the Alliance Trust, for example, has moved out to trade on a discount of more than 16%, it begins to look good long term value. Anyone buying the Alliance shares now is effectively buying an index fund at 83% of asset value.

So while holding cash is not wrong while the current panic plays itself out, it is worth making the point that the purpose of holding cash is to reinvest it at some point. A market panic that depresses valuations indiscriminately always produces some bargains and now is the time to be looking out for them.

The medium term outlook is not materially worse than it was. Indeed to the extent that the current market turmoil removes some of the distorting factors of the past 2-3 years, absent a severe economic downturn this could become an excellent buying opportunity for shares in quality companies and also Asian emerging markets.

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Finally a reminder that the next Independent Investor conference will be held in London on September 18, and will feature a range of topical speakers, including the financial historian Edward Chancellor talking about credit crunches - what happens when they happen. If you are interested in finding out more about the conference, do have a look at the relevant pages on the website. 

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