The Reckoning

With the summer reporting season now upon us, those looking for some relief amidst the bearish gloom are likely to be disappointed. Whilst pharmaceutical stocks like AstraZeneca staged a recovery last week, other traditional defensives like BT have been punished after reporting a lower than expected rise in first quarter earnings. Expect trading to be extra light once the Olympics start.

 

Several asset managers who have traded through previous bear markets have pointed out that the race to the bottom has been much quicker this time around, possibly due to the sizeable participation of hedge funds. “The market fell out of bed at the start of June and over a six-week period we had a precipitous fall in share prices,” says Alan McIntosh, CIO of Cheviot Asset Management. “In past bear markets it has tended to take several months for share prices to fall so far, but the market reacted very quickly and has already priced in a deep economic downturn.” Because of this, McIntosh believes the current bear market may be one of the shorter-lived ones. “Bear markets tend to run for about 12 to 15 months, so it may run another three to six months.”

 

Adam Steiner, head of research for public equities at SVG Capital, believes that active trading by hedge funds is partly behind the accelerated share price fall. He points out that global hedge fund assets under management have increased from under US$200 billon in 1995 to over $1.8 trillion in 2008. As a result, over the last decade the average holding period of FTSE 350 stocks has collapsed. “In the mid-1990s it was about two years whereas now it is down to five or six months,” he says. “In mainland Europe the fall isn’t as pronounced due to large bank and family stake-holdings, but it is still down from about 18 months to 10 months.”

 

Know your rights

The rise of hedge funds has also created a conflict between financial markets and the real economy. “Until this bear market we never had a significant number of people who make money if a company goes bust,” he says. This has been reflected in the recent rights issues by the banks, where HBOS only managed to attract an 8% take-up because its share price was driven below the rights issue offer price.

 

Regulators have responded with a temporary ban on naked short selling in the US, and the disclosure of trading in rights issues in the UK market. “But the reason why the banks are trading below their rights issue price is more to do with the fact that they are in trouble, and people think that there will be further fund-raising,” says Steiner.

 

He points out that once, no one would have benefited from a rights issue failing so there was pressure for them to go ahead. Investment banks can make a lot of money from rights issues and they allow struggling companies to continue trading. But now hedge funds can express a view that a rights issue is priced incorrectly, and they will make money if that view is borne out. “Hedge funds remove muddled thinking from the market – they take prices very quickly to what people think they should be,” says Steiner. “That removes the ability of markets to muddle through, and muddling through can be quite useful at times.”

 

Steiner believes the pending UK recession could be as bad as that of the 1990s, and possibly that of the 1970s, but for totally different reasons. “The basic problem is that central banks have spent the last 15 years trying to iron out the economic cycle, and their focus has shifted from controlling inflation to steady growth,” he says. “In the US, whenever there was the slightest hint of a normal slowdown, Greenspan tended to throw money out of helicopters as fast as he could.”

 

This approach has led to a 15-year accumulation of poison in the system, which needs to be sweated out. “Unfortunately the banks are realising they have a problem at the same time as companies are at peak profit margins. So we would expect corporate earnings to come down even if nothing else was happening.”

 

Across the market, equities are now trading at comparable levels to the trough of the 1990-1992 recession. “The FTSE is trading at P/Es of 10.5x, against a trough of 10.4x in 1991, whilst bank stocks are at 5.4x, compared with a long-term sector average of 12x,” says Richard Moore, manager of the Santander UK Growth Fund.

 

A short squeeze

Ironically, financials have become so over-sold that they staged a rally in July, and are up a modest 1.73 percent over the past month. Peter Lucas, global strategist at Ashburton, attributes this bounce to a period of short covering rather than any change in the fundamentals, and Steiner remains wary: “The UK banks still haven’t taken any write-offs relating to the domestic economy [although the likes of HBOS have increased their provisions to cover bad debt], and our view is that there is no point investing in contentious sectors as the rest of the market is so cheap.”

 

McIntosh is also cautious about the bank bounce: “It is probably a bit risky to load up with those yet because we haven’t heard all the write-offs, and if a recession occurs then all the bad debts will start to come through.” But he adds that some banks haven’t been caught out by sub-prime and will be able to take market share from the weaklings.

 

Other sectors being given a wide berth by managers include companies that are vulnerable to higher input costs, such as food manufacturers, and consumer businesses that are operationally leveraged. “The impact of slower sales will be magnified by competitive pricing and rising input costs,” says Colin McLean, manager of the SVM UK Active Fund. “A feature of a number of consumer companies is higher balance sheet debt.”

 

He points out that buy-backs and stock tenders in recent years, combined with high levels of dividend distribution, have meant that many consumer businesses will enter the slowdown with a weaker balance sheet. This will trigger dividend cuts and force some companies to renegotiate banking covenants – something that appears likely to occur with some UK house-builders. McLean expects weak trading to combine with margin pressures and balance sheet problems to trigger further share price falls in many UK consumer businesses.

 

In such an environment, Steiner says SVG is looking for companies that aren’t reliant on the cycle to generate profits, and are on an attractive valuation, with no major structural problems. As a result, he likes pharmaceuticals, telecoms and non-cyclical industrials, but is frustrated by the sell-side analysis of telecoms, which he believes has made a wrong call on every major development since the dotcom blow up. “It seems like they got so burned by the TMT bubble that now they always assume the most negative outcome of any story affecting the sector. So telecoms, which should be a defensive, hasn’t been from a share price perspective, even though the quality of the management in UK telecoms is the best by a mile.”

 

Good hunting grounds

Steiner also believes that small caps have been unfairly written off because of the widespread perception that they do poorly in bear markets as liquidity dries up. “But between 1970 and 1979, small caps outperformed the FTSE All-Share by about 200 percent. Our view is therefore to buy small caps because they have fallen the most.” This means looking for individual stories because small caps are vulnerable to banks pulling their funding or changing the terms of their financing.

 

Another good hunting ground during a downturn is where private equity deals have failed to come to fruition, as companies wise up to their real value. “We are seeing more talks that don’t go anywhere, where one side is looking for a bargain and the other is looking for fair value,” he says. If the private equity house walks away because it found something in due diligence that it didn’t like, Steiner says SVG will steer clear. “But if the private equity firm walked away because the company’s managers are holding out for a good price, then it could be worth looking at.”

 

As traders and asset managers head for warmer climes and market volumes thin, a major sell off in miners and energy cannot be far away. July’s fall in the oil place has ensured that commodity-related shares have already taken something of a beating – and given that the resources sector has been the FTSE’s life support for the last six months, this is likely to prove fatal.

 

“The problem is that there is very poor breadth in the market with a concentration in resources and mining stocks – only a few shares have participated in the upside and we need to see that broaden out,” says Lucas. “But over the last few months, even though the oil price has been going up, oil-related shares haven’t followed it. I think the reason for that is people did not believe that the oil price was sustainable at those levels.”

 

If you want to read more about how asset managers are positioning their portfolios in the bear market, please visit:

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