How to prepare for a market crash

The US stockmarket has hit new highs – which most people think is good news. But don’t get out the champagne just yet, says Paul Hill…

The US economy is the largest in the world: it's worth some $13.5trn. Its nearest rival, Japan, is worth a mere $4.4trn. It follows, then, that the health of the US stockmarket is central to that of global markets. When America is doing well, so is everywhere else and, as the adage goes, when Wall Street sneezes the rest of the world catches a cold. Given this, it was considered by most to be very good news when the S&P 500 and Dow Jones hit fresh all-time highs two weeks ago and this after a two-year bull rally.

I'm not so sure. The excesses of the global economy are making me nervous. In the UK, property is simply unaffordable, except for the lucky few; City bonuses are astronomical; and takeover speculation is rife, with banks even financing deals on loss-making terms. It feels like a peak rather than the middle of a bull run. Calling the top of the market has generally proved a mug's game, so I'm usually reluctant to attempt it. But right now, the odds of the market coming a cropper are so high that all investors should take note of the signs.

It's conceivable that the FTSE 100 could keep going up, but I'd say that there's only a 5% likelihood of that happening. I see the FTSE ending the year at more like 6,025 than 7000 (it is currently at 6,513.8). I also estimate there is a one in four chance that it could really crash, falling over 20% to 5,500 or below.

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Three reasons to fear a market crash

I'm not the only one thinking this. Last week, Morgan Stanley forecast a "14% correction over the next six months", but also noted that "it could be more serious" and advised clients to slash their exposure to equities. So why is there cause to worry? I think there are three main things to be nervous about. They're all bubbles, they're all at risk of bursting and they're all likely to bring other markets down with them when they do.

1. The mergers and acquisitions frenzy

The mergers and acquisitions (M&A) boom has been driven by the over-flowing pockets of the private-equity sector. Many firms valued between £100m and £10bn, particularly in the retail, utility and leisure sectors, have become bid targets. What these sectors have in common is strong asset backing (eg, property) and reasonably reliable cash flows. However, as a result of the feeding frenzy, much of the remaining prey now trades on unsustainable 2007 p/e ratios of 20 to 30 times. On fundamentals, I would value these stocks on p/e multiples of more like 12 to 18 times. That's 30% to 50% less than their current prices, which, to my mind, makes them too expensive not only for us, but also for private-equity companies.

Private equity doesn't seem to agree, but that just leads me to believe the buying binge will end in tears particularly given that UK banks are now muscling in on the fun (or folly) of the whole thing by lending at unprecedented and absurdly low rates. Rates in many places around the world are artificially low anyway (due in the US to the massive number of bonds being bought by the Japanese, Middle Eastern, Chinese and Asian central banks, something that has pushed yields down). Yet now, for the first time since records began, loans from banks to buy-out teams are being charged at below the base rate.

The net result is that private equity has been able to raise money with few strings attached through Cov-Lite' loans. Most of the standard terms that protect banks' money have been stripped away, which enables increasingly aggressive bids. How can this not end in tears?

2. Over-priced property

City bonuses and cheap buy-to-let mortgages have driven UK demand for property, but there has also been an influx of foreign capital from the traditional petro-dollar' nations, such as those in the Middle East and Russia. This has driven residential and commercial property prices up to levels where they make no economic sense. Commercial yields in London are typically 4.5%, but interest rates are more like 5.5%. This means that landlords are losing money. Still, the UK isn't the only place where house prices have been raging out of control. The same is true in the US and Spain, although in these two countries prices have already started to deteriorate.

3. Over-excitement in China and India

The Indian stockmarket trades on a p/e ratio of around 19 times earnings and has doubled in the past two years. While 19 times may not sound too expensive, when you put it alongside India's over-heating economy (inflation is running at 6.7%) and the geopolitical risk that comes with the market, it is priced pretty much to perfection.

Then there is China, probably the most overvalued time-bomb of all. The Shanghai benchmark blasted through 4,000 in May and is 250% up on its levels of only 12 months ago. The average Shanghai share trades on a p/e multiple of between 40 and 50 times compared with an average of 14 to 18 times throughout the rest of Asia: the prices now being paid for Chinese shares are completely out of kilter with profits. This is crazy, and at some point there will be one almighty crash, which will make the recent wobbles look very minor indeed. Three weeks ago, former Federal Reserve chairman Alan Greenspan warned: "There is going to be a dramatic contraction at some point." Investors should heed his warning he is probably right.

What would trigger a market collapse?

The next question to ask is what might trigger a sell-off and when it might happen. There are five major catalysts that could lead to a real collapse.

1. Slower US growth

The US consumer is already over-stretched with debt (see charts), and can't continue to be to relied on to prop up the global economy. US GDP slowed to a crawl at 0.6% in the first quarter and has grown by just 1.9% in the past four quarters well below the 3% most economists claim is the long-run trend. The chart below shows the rise in consumer debt as a percentage of GDP.

Assuming US consumers decide to tighten their purse strings something getting increasingly likely as $3-per-gallon petrol prices start to bite we should see a brake on spending, which will translate into weaker corporate earnings. Wall Street is forecasting full-year 2007 earnings growth for the S&P500 of 7.3% the weakest level since 2002. This is not a euphoric environment. I don't think it will take much in the way of disappointment for fund managers to twig that the days of constant double-digit earnings rises really are over. Share prices will be bid down as a result.

2. American property turns uglier

The number of US home sales has fallen over the past year (see chart), but prices have also stalled. This could get much worse, given how much debt the US consumer has and particularly if interest rates continue to move upwards.

3. A blow-out in private equity

Private-equity returns have been very good thanks to benign economic conditions and ready access to debt. But at some point there will be a major blowout in this outrageously geared sector. Many deals have gone ahead at too high a price, putting them at risk should things go even slightly wrong. If there were a couple of big defaults, lending rates would spike as banks tightened their credit rules this would turn off the cheap-debt tap and hit M&A activity.

And if the cost of borrowing continues to rise, perhaps triggered by higher inflation, then it is going to get a lot more difficult for these leveraged buyout teams to continue paying top dollar for acquisitions. The yield on ten-year US Treasuries has already jumped by 0.5% in the past month and now stands at 5.1%.

4. Sudden dollar devaluation

Another major risk that's not always well covered in the media is the impact of a sharp devaluation in the dollar. The greenback has been under constant pressure over the past five years, mainly because of the US trade deficit. In April it hit $58.5bn (see chart) and it came to a Himalayan $818.1bn for the whole of 2006, with China accounting for a whopping $232.5bn (or 28%) of the total.

Basically, America's foreign trading nations have to buy a staggering $2bn worth of dollars per day just to keep the currency afloat. If they stopped, disaster would soon follow. Were the US currency to dive fast, it would push up the price of imports overnight. That would lead to a sudden leap in inflation and US interest rates would have to rise fast, which could easily lead to a global recession.

Yet one more thing to worry about on this score is that the Chinese yuan is presently pegged to the dollar at around /$ 7.7. This has artificially boosted Chinese exports (making them cheaper than they would be if the yuan floated freely) and generated amazing growth. However, when this control is removed and the currency is allowed to float, there will be one almighty shock to global trade (note this is unlikely to happen before the Beijing Olympics).

5. A Chinese crash

A stockmarket crash in China is a matter of time. How will this affect the rest of the world? Most pundits think it won't affect it very much, but I disagree. The interdependency of capital flows and the size and importance of China in moderating global inflation means that London, New York and Japan will surely be affected if China crashes as will other emerging markets. Last week's wobble (when the Chinese market fell 15%) didn't have an effect, but I think a crash would. The unknown is exactly what the extent of the impact will be. Think back to February, when a 9% sell-off in Shanghai sent shockwaves around the globe.

Finally, by the end of 2007, Beijing will have spent a hefty $35bn-$40bn on constructing venues, transport, urban renewal and environmental projects for the Olympic Games. This work has temporarily boosted the economy, but when complete, could soften the nation's growth rates and take the heat out of commodity prices.

Given all this, I am convinced that over the next six months there is a 50% chance of a correction (say up to a 10% fall), but also a 25% probability of a stockmarket crash. To find out what to do about it, see the box on page 24.

Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments

Market crash: How to prepare for a rocky ride

Bubbles rarely pop up everywhere. For one sector to rocket, institutions have to be underweight in other sectors in order to fund the buy. The trick for canny investors is to have the nerve to cut your exposure to bubble areas when the time comes and put the cash elsewhere. In other words, sell high and buy low.

Consequently, my top picks for the more cautious investor would be the mega-caps, which have fallen out of favour due to the the mergers and acquisitions boom. Global companies with well-known brands offering good dividend yields look especially attractive. Citigroup (CGP), Wal-Mart (WAL), Shell (RDSA), Lloyds (LLOY), Altria (MO:NYSE), Glaxo (GSK), Conoco (COP:NYSE), Chevron (CVX:NYSE), Aviva (AV), Group4Securicor (GFS) and HSBC (HSBA) all appear to be sound long-term investments.

For the more adventurous, there is another area that has been largely unaffected by the M&A boom: the micro-caps with valuations below £100m. Here it is still possible to buy quality companies on historically low p/e ratios, with the added bonus of organic growth potential and sector consolidation. COmpanies of particular interest include MTI Wireless Edge (MWE), Fonebak (FON), Conder Environmental (CDE), Mobile Streams (MOS), Acertec (ACER), Financial Objects (FIO), Minorplanet (MPS) and Asian Citrus (ACHL).

However, if you are already fully invested and are sitting on some hefty profits, then it might make sense to consider using your annual capital gains allowance of £8,800. Capital preservation is the number-one rule at times like this. Nobody ever went broke taking a profit rather than hanging on in the hope that an overvalued share will rise even higher.

Alternatively, gold currently trading at $670 per ounce is an interesting play.

The yellow metal provides insurance against unforeseen events or financial catastrophe. Gold's value as a safe haven is illustrated by its behaviour during periods of financial turmoil. However, if you are looking for security with a decent return, then high-interest sterling accounts or Canadian dollar accounts seem sensible.

What should you sell?

I would sell out of the bubble sectors entirely, or at least take profits. My list of sells includes retailers for example, Sainsbury's (SBRY), Marks and Spencer (MKS), and Tesco (TSCO)); pub groups (Enterprise Inns, ETI); utilities (Severn Trent, SVT); consumer-goods manufacturers (Reckitt Benckiser (RB) and Diageo (DGE), for instance); recruiters (such as Michael Page (MPI)) and business-process outsourcers (AMEC (AMEC), for example). All of these stocks are pretty much priced to perfection, offering minimal upside but significant downside risk.

I have already followed my own advice. Twelve months ago, I was 95% invested in equities. But following the run-up in the market, I now hold about 40% of my portfolio in cash. To be a buyer of bubble stocks now, you have to believe we're in a new era of global growth and that we're somewhere near the start or in the middle of the trend. This scenario does seem very far-fetched. Put on your hard hats.

Paul gained a degree in electrical engineering and went on to qualify as a chartered management accountant. He has extensive corporate finance and investment experience and is a member of the Securities Institute.

Over the past 16 years Paul has held top-level financial management and M&A roles for blue-chip companies such as O2, GKN and Unilever. He is now director of his own capital investment and consultancy firm, PMH Capital Limited.

Paul is an expert at analysing companies in new, fast-growing markets, and is an extremely shrewd stock-picker.