The return of risk

Markets have been hugely volatile over the last few weeks. A mere correction, say some. A buying opportunity, say others. But could we be witnessing the first signs of something more serious? asks Merryn Somerset Webb.

Markets have been hugely volatile over the past few weeks. But no one seems worried. A mere correction, say some. A buying opportunity, say others. Is that true? Or does it presage something more serious? Probably the latter, says Merryn Somerset Webb

The last few weeks have been tricky for global markets. The details will be familiar by now: on 27 February, the Chinese market fell 9%, other Asian markets tanked in sympathy, the European markets followed, and then, when the US opened, the Dow promptly fell 416 points in a day its biggest one-day drop since the markets reopened after September 11th 2001. The rest of the week was little better, with global markets ending 5% down on average, and even this week didn't get off to much of a start: the Dow and FTSE were unusually volatile on Monday. However, by Tuesday things had stabilised US and European markets both ended the day up strongly and by mid-week the panic seemed to be over.

With a few exceptions, the world's commentators have been remarkably unfazed by all the turmoil. The Economist referred to the whole thing as a "wobbly week" and, despite not having expected them, almost all other journalists called the mini-crashes around the world "expected corrections".

The fund managers weren't having any bearish talk either. "Our advice is to stay invested," said a strategist from JP Morgan. "Nothing has happened that affects our view of the world and the positive outlook for equities," said Dominic Rossi of Threadneedle. "Our managers have not changed their optimistic view for the year," said New Star's representative. This is a "good buying opportunity", said Deutsche Bank strategist Bernd Meyer. In fact everything, said everyone, is just fine.

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Investment risk: why falls could trigger a sell-off

But it isn't. The bulls have been at pains to point out that the falling Chinese market is not much of a big deal: after all, a market that has risen 130% last year alone and 13% in the week before the 27th was always bound to trip.

But this entirely misses the point. China may have triggered falls elsewhere, but those falls weren't actually about China. Remember the dotcom crash? The sudden falls in the US indices then were not related to Japan, but were kicked off by a 13% slide in one of the Japanese indices. All that is required for an event to become a trigger for a sell-off in an overvalued or overly complacent market is that it should make investors suddenly feel a bit nervous. That's exactly what the sell-off in China did: it reminded global investors that markets don't move in straight lines, that risk exists, that the world is full of political tensions and that, in markets full of speculative froth, once prices start falling, they can fall very fast indeed. Institutional investors may now be claiming to have recovered from their bouts of nerves and to be out taking advantage of all the "buying opportunities" offered by the "correction", but I bet they are still feeling a tiny bit less calm about their risk exposure than they were two weeks ago.

Investment risk: is a crash on the way?

The question now is just how jumpy they should be feeling. There is no way that recent events could be called a crash, but is it possible that they will be followed by a crash? The first thing to look at here is valuations. Are markets cheap? Most people insist that, in Western markets at least, they are. But in doing so, they may be looking at the wrong numbers.

The average p/e in both the US and the UK is around 16 times not far off long-term averages. But this alone doesn't really tell us anything. Why? Because, as Martin Wolf points out in the FT, corporate earnings are intensely cyclical, so you have to look at the current p/e and ask whether earnings can be maintained, or whether they are likely to fall back. Clearly, when times are good and profits are high, p/e multiples should be relatively low, as investors should assume that profits are unlikely to keep growing fast forever. The world has experienced an "enormous surge" in corporate earnings in the last few years, says Wolf. They rose a massive 192% between March 2002 and December 2006 and have been on the up at double-digit rates for 19 consecutive quarters.

Yet over the last quarter century, earnings growth has averaged a mere 3% in real terms. So to think that this can continue is to "confuse a cycle with a trend". Instead, "on past experience", growth is "more likely to turn negative". One way to account for this in a valuation is to look at the cyclically adjusted p/e ratio of the market the ratio of stock prices to the moving average of the previous ten years' earnings, deflated by the consumer price index. Do this and you get a p/e of 26.5 times, according to data from Smithers & Co. This is not as high as it was in 2000, but, says Wolf, "it is very high by historical standards". According to Smithers, on this measure, the UK market is now more than 60% overvalued. Another way to look at the valuation question is to study the PEG ratio for the market as a whole. This ratio too has been warning of trouble to come: it recently hit a five-year high. The upshot is that Western equities, in the main, are not cheap. And as earnings start to fall back, that will become increasingly clear.

Investment risk: what will make earnings fall back?

The next question is what will make earnings fall back? Recession in the US would probably do it. Alan Greenspan has been irritating his successor all week by saying that he thinks recession is possible by the end of the year (he gives it a one in three chance) and the numbers certainly seem to be backing him up. We wrote last week about the problems in the US sub-prime mortgage market and the housing sector is clearly going to become a massive drag on the US economy, perhaps even finally persuading US consumers to tone down their spending.

According to John Mauldin, mortgage equity withdrawal accounted for 2% of the 3.4% GDP growth in the US last year. Take that off and then knock off another 1% for construction (which is disappearing as house prices fall) and you aren't that far from recession. Then consider the data out this week. Productivity growth for the fourth quarter of 2006 has been revised down from 3% to 1.6% and unit labour costs have been revised up from 1.9% to an annual rate of 6.6% for the same quarter, which will be making inflation-conscious Fed chairman Ben Bernanke feel a tad nervous.

Factory orders fell 5.6% in January the biggest fall since 2000 and core capital goods orders fell 6.3%. Worse, there is no sign of a let-up in the housing-market gloom: the builders were putting their faith in the spring selling season, but so far it's got off to a lousy start. Houses are sitting empty for months waiting for a sale and those working in foreclosures are utterly exhausted by all the business coming their way. All the signs suggest a recession to come. Indeed, earnings growth for the first two quarters of this year is already forecast to come in at only 5%. If this turns out to be the case, it will be the biggest drop since early 2000, a few months before the US dropped into recession.

Investment risk: has the recession already begun?

Or perhaps recession is here already? Revised GDP numbers for the fourth quarter show growth at just 2.2%, but that doesn't mean it won't be revised down further. In late 2000, says Martin Hutchinson on Breakingviews, third-quarter GDP was put at 2.7%. "The figure was then steadily revised downwards over the next three years, falling below zero only in a final statistical revision in December 2003, more than three years later." Given the weak data, there's no reason why something similar shouldn't happen this time. And as it takes so long for the data to be finalised, says Hutchinson, "we probably won't know finally until about 2011", but investors shouldn't discount the possibility that, on the strict definition of two quarters of negative GDP growth, the US is already in recession and earnings will soon reflect this.

So there you have it. Stocks in the UK and the US are too expensive and the US isn't as far from recession as many think. This is dangerous in itself. Then there's inflation, which is still a major threat (the rise in unit costs in the US shows that there, as in the UK, price rises aren't confined to commodities), and makes it hard for central banks to cut rates. Add in the technical factors affecting markets (ie, the number of people involved in the yen carry trade) and political risks and you've got a recipe for disaster. We can't be sure when a crisis will come, but we suspect events last week were a taster of what might happen later in the year. Investors have been too complacent about risk, which has been obvious in the fact that credit spreads have hit historic lows (ie, people currently don't demand much more of a return from owning risky assets than safe ones). This situation will reverse. I can't say when, but odds are it will be around the same time that the truth about the US economy filters through the bulls' rose-coloured glasses.

How MoneyWeek sees the situation

The market blip of the last few weeks has had no real effect on the MoneyWeek view of the world: we really were expecting it! We still think that investors are best off out of the US market and the Chinese market (you are better off getting your Chinese exposure via Taiwan or Japan). We think that UK markets should be approached with caution (with a bias towards very cheap small caps and cheap blue-chips). We think that Japan remains a good buy. Anyone who took our advice to buy in a few weeks ago will have made money on the currency (the rush to get out of the carry trade has pushed the yen up), only to lose it in the market itself. However, the fundamentals of the market remain solid and there is no reason to think that a strong yen is necessarily bad for the market. On the contrary, as Jonathan Allum of KBC points out, historically a strong yen tends to coincide with a strong market. It is the recent combination of weak yen and strong market that has been the aberration', rather than the other way around.

Finally, we remain keen on commodities. The super-cycle story is based not on US growth, but on the fact that, as John Stepek says in MoneyMorning, the scale of the urbanisation and industrialisation challenge facing China and India is huge, and has years, if not decades, to go. People in emerging and developing economies want all the things we take for granted air conditioning, fridges, cars, a roof over their heads and that is going to take a lot of raw materials. We still like Xstrata, Rio Tinto and BHP Billiton the latter being the share MoneyWeek regular Tim Price picked as his must-have' stock for 2007.

The rule of 8.6

Most analysts are useless at forecasting and famously so. But not, apparently, Martin Armstrong. Armstrong developed a theory focused on the idea that there is an intense turning point in markets every 51.6 years, with six lesser turning points at 8.6-year intervals inside these longer cycles. Yes, it sounds slightly mad, but it does appear to work. In fact, according to, "the 8.6 year rhythm" worked in a remarkably prescient manner, often predicting market turning points "almost to the day". It predicted the 1987 crash (to the day), the peak of the Japanese bubble and the S&P bottom in 1994. Most interestingly of all, however, Armstrong's system suggested that 0.15 of the way through 2007, the next 8.6-year turning point would kick in. And what date does that work out to? 27 February.