Generally, a correction of say 10% is considered healthy within a long-term bull market, but if it extends beyond this level it normally signals that something is lurking in the woods.
The bull case for equities revolves around strong corporate earnings, cash flow and low relative equity valuations. Increased M&A activity and record world growth have helped but these two drivers could be peaking as financing takeovers becomes more expensive and leading indicators appear to be rolling over.
As long-term interest rates have finally moved up, the phenomenal US consumption binge could be coming to an end. But few observers believe that it is the beginning of a bear market and hope that growth in the Far East and Europe can compensate.
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For markets to resume an uptrend it will take some evidence that favourable growth conditions are continuing or that these are not to be blown off-course by either hawkish central banks or by highly indebted US consumers cutting back as the housing market crumbles.
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So far, the Dow Jones Industrial Index has been a pillar of strength in these recent volatile markets. Although UK equities appear to offer value, if US stock indices start to take fright, other equity markets could test that 10% threshold.
Generally, equity markets hit a peak in early May (FTSE All World Index beat its dot.com high and Emerging Markets set new highs beyond 1998 levels) except for a few markets such as the UK which topped out in April. Globally, the best performing stock market sectors for the year to date are Industrial Metals (+25%), Mining (+24%), Industrial Engineering (+16%) and not far behind are Oil & Gas and Utility shares. Below, we look at some of the sell-offs in various markets.
In the UK, it should come as no surprise that since the UK equity market peaked in April, the best performing sector has been Fixed Line Telecoms (+4%) and other traditional defensive sectors are not far behind such as Industrial Transport (-1%), Food Retailers (-2%) and Utilities (-3%).
Since April, the FTSE 100 has fallen by about 7% to 5,723 (at its worst it had fallen 9.7% to 5,532) and the FTSE 250 mid cap after scaling the 10,000 level, then slumped by 13% and it has recovered to show a fall of 8%.
The UK equity market is trading on a P/E ratio of 12.5x for 2006 and 11.7x for 2007 indicating about 9% and 6% earnings growth respectively. Dividend growth could be 11% in 2006 and possibly 8% in 2007.
The US equity market has been a big surprise in these volatile markets. The Dow Jones Industrial Index has remained steady and is only 4% lower than its May peak. Similarly, the S&P 500 Index has only fallen 4.2%.
Although these resilient performances are comforting, the US investment risks (e.g. dollar and deficits) are increasing. In addition, US consumer spending growth in recent years has been driven by the wealth effect mainly from the housing boom and mortgage equity withdrawal. Higher interest rates and the slowdown in the housing market which is underway will have a marked impact on future domestic spending.
In Europe, the FTSE Euro (ex-UK) Index is currently down 8% from its peak after a 9% initial fall. Both the German and French equity markets are about 7% lower. Across Europe, monetary tightening by the European Central Bank (ECB) and Scandinavian central banks continues and an increase in ECB interest rates is expected on 8th June. The eurozone economic cycle is different to the UK with higher unemployment, a 15% savings rate in the major economies and less indebtedness.
In Japan, the Nikkei Index is 12% down from its peak. The economy is starting to benefit from a recovery in consumer spending but equities are vulnerable to any slowdown in export markets whether it is the US, China or other Asian economies.
Emerging equity markets had risen the most over recent years and so it is not surprising that they have shown the biggest pull back. One could argue that earlier setbacks in financial markets of Iceland, Hungary, Turkey and the sharp declines in some Middle East equity markets were a precursor to the current turbulence in other markets. In May, the FTSE Emerging Market Index has fallen 14% from its peak. Russian and Indian equity markets have fallen by 16% and 17% respectively.
Conclusion
In May, equity markets have been spooked by a new bout of dollar weakness combined with fears that central banks (in particular the Federal Reserve) have more monetary tightening to do in order to reduce inflationary expectations.
However, there is a clear strategic change underway with the unwinding of global liquidity and at the same time, record levels of debt are being used to leverage private equity deals.
As a result, some de-risking of investors' portfolios has occurred. With June set to bring further central bank decisions on interest rates, a key concern is how fast the US economy slows on the back of a weaker housing market, strong gasoline prices and higher interest rates.
If financial markets get scared about the growth prospects we could see further volatility. Normally, market corrections last a couple of months unless a catalyst speeds up the process and so far any rally seems to lack conviction.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley
