Signs look positive for global shares

Two of our key 'predictions' for this year were for a global economic recovery (albeit mild by past standards) and a cyclical rebound in major equity markets.

However, for a year in which the global economy is starting to recover from its slump last year, Western equity markets have been surprisingly weak.

Year-to-date the US market is down 13%, Europe is down 19% and the UK is down 13%. In NZ dollar terms these returns are US down 27%, Europe down 25% and UK down 24%. This is the result of the rapid appreciation of the NZ dollar which is now up 19% year to date against the US (and 12% on a trade weighted basis).

In fact, these markets are getting close to the levels we saw during the panic period last September. So what's going on?

Global recovery is on track...
First, let's look at the economic recovery - which is still on track. Leading economic indicators are moving higher for all major regions, including Japan.

Economic growth was positive in the US, Japan, most of Europe and throughout Asia in the March quarter.

Global industrial production is starting to turn up. Consumer and business confidence is up from its lows post-September 11.

While the US market last week made much of weak US retail sales in May, this followed a stronger-than-expected sales result in April and in any case weekly surveys suggest that US retail sales may have recovered in June.

...so why are equities still weak?
In our view there are several reasons for the apparent disconnect between the global recovery and the global equity market:

Firstly, there remain two dynamics at work in equity markets - the cyclical economic upswing (which is positive) and the ongoing and seemingly relentless unwinding of the 1998 bubble in technology and telecommunications stocks (negative).

For some countries the cyclical influence is dominant (eg, South Korea up 10% year-to-date in local currency and down 1% in NZ dollar terms) or the influence of technology is minor (eg, in the New Zealand market).

However, in the US and Europe the slide in tech. and telco. stocks (reflecting weak corporate capital expenditure and still-rich valuations) remains a dominant influence in overall market indices.

While Nasdaq (dominated by new economy stocks) is close to its September lows, the Dow Jones index (dominated by older economy stocks) is still well above it.

Secondly, the revelation of creative accounting at Enron, Tyco, etc. has left a cloud hanging over US corporate earnings generally and hence equity market valuations, with investors increasingly sceptical about the true level of earnings.

While this is a typical post-bubble phenomenon, it has made the US equity market doubly sensitive to any bad news - far more sensitive that we anticipated.

Thirdly, the boost to equity markets that might have been expected from easy money conditions (strong money supply growth and the lowest interest rates in over a generation) has not transpired.

In the US, liquidity appears to have been diverted to consumer spending and the housing market. More fundamentally, US companies have stopped buying shares - corporate issuance is robust and stock buy-backs have ground to a halt as companies have sought to reduce their debt levels. This contrasts with the 1990s where the corporate sector was a strong buyer of US stocks.

Fourthly, the modest nature of the recovery is leading to uncertainty about the extent of the profit rebound.

We have always been looking for a sub-par or soggy recovery by past standards. The downturn in the US last year was mild so it stands to reason that the upswing will be mild as well.

However, it is now clear (with hindsight) that most equity investors were looking for something stronger.

Finally, geo-political tensions and the threat of more terrorist attacks have dampened investors' risk appetite.

Equities at or approaching a low point
While these considerations may explain the recent past they don't necessarily tell us much about the future. Our 6-12 month view of equity markets is driven by three key factors: valuation, earnings and liquidity. These are now becoming more positive.

• Valuations - whereas equity market valuations were neutral to modestly expensive three months ago (as measured by a comparison of bond and prospective earnings yields), the recent fall in share prices and bond yields have pushed them back towards modestly cheap readings. On this basis the US market is almost as cheap as it was last September.
• Earnings - analysts' company profits estimates may not be being upgraded but they are no longer being downgraded aggressively. Conditions are falling into place for a recovery in profits in the US and elsewhere - unit costs are being kept under control by weak labour costs and strong productivity growth and volumes should improve modestly with economic recovery.
• Liquidity - liquidity conditions remain hazy but with interest rates remaining low and US money supply growth showing signs of reaccelerating (after slowing though much of this year) it is hard to describe conditions as negative and things may be starting to become positive again.

Thus, on a six month view valuations and earnings should rate as positive for equity markets.

However, the big issue is when these positives will start to have an impact.

Here, the US market is the key as it seems to drive direction for the European and UK markets (which together account for 85% or so of global equity market capitalisation).

Trying to time precise bottoms is like trying to catch a falling knife, but many tactical indicators are at or near buy levels.

Sentiment is very pessimistic amongst US retail investors and equity market traders - this is a good sign from a contrarian perspective because it indicates that many potential sellers have already sold.

This is confirmed by flows into US equity mutual funds, which had been picking up but in the last few weeks have been negative. This often coincides with a bottom - again a contrarian signal.

Consistent with this, option volatility levels have increased sharply and the ratio of put to call option volumes has increased (indicating that investors were becoming nervous and were seeking to protect their portfolios) - again a positive signal from a contrarian perspective.

Finally, short-term indicators suggest that equity markets have become very oversold in a technical sense.

Conclusion
At times like the present and last September it is easy to get scared by the thought of waves of selling knocking share prices into a financial abyss. However, nine times out of 10 the financial system stabilises and does not self-destruct.

At present, the combination of improving equity market valuations, economic recovery leading to some earnings recovery, accommodative liquidity conditions and a high level of negative investor sentiment are positive signs for global sharemarkets.

Of course none of this analysis rules out the US share market moving down to retest the September low and forming a double bottom (not an unusual phenomenon historically).

However, it does suggest that we may be at or getting close to a low point from which share prices should rebound.

One point to keep in mind though - we are looking for a cyclical rebound in stocks. As we have explained elsewhere investors should not expect a quick return to the days of sustained high double-digit returns from stocks.

The next decade or so will see much more subdued returns on average. One implication is that we will have to get used to a bumpier ride than what we were used to in the long bull market from 1982 to 2000. There will be a greater tendency for investors to chase promised performance and this will likely create a lot of volatility.