Investment perspective

November 2008

Value versus volatility

ALTHOUGH MARKETS ARE LIKELY TO REMAIN VOLATILE FOR SOME TIME, VALUATIONS INDICATE THAT EQUITY RETURNS SHOULD BE REWARDING FOR INVESTORS WITH A LONGER-TERM HORIZON.

Over recent weeks, all financial markets have been exceptionally volatile. Equity market volatility has been more extreme than at any time since the 1987 crash, and the scale of daily moves in all asset classes has been about five times as great as would be expected in normal market conditions.

The pervasiveness of this volatility points to a major underlying cause, and this is to be found in the inter-bank lending market. After the collapse of Lehman Brothers in the middle of September, banks became concerned both about the soundness of each other’s balance sheets and about governments’ willingness to support financial infrastructure at times of extreme strain.

Consequently, the supply of term liquidity – cash that is on loan for longer than an overnight period – effectively seized up. This rapidly affected leveraged investors – in other words, those whose holdings of securities were funded through term liquidity arrangements with banks. As term liquidity disappeared, these investors were forced to sell, which drove prices down, thus increasing the margin calls for other leveraged investors, who in turn became forced sellers, and so on in a vicious circle.

Such an environment of forced selling is both destabilising and selfpropelling. So the immediate policy challenge confronting central banks and governments was to return term liquidity to financial markets. These policies – including the recapitalisation of the banking system, the guaranteeing of short-dated bank paper and direct intervention in money markets – have met with a large degree of success. Though still strained, the inter-bank lending rates for three-month term liquidity in all major currencies are now back to the levels they were at before the failure of Lehman Brothers.

So the immediate crisis has passed. Yet the problems and dislocations it produced will persist both in financial markets and in the real economy for some time to come.

Investment Review

• Policy-makers have taken a series of steps to counteract the seizing up of money markets, while central banks have cut interest rates in order to stimulate growth.


• That should prevent a depression, but growth is likely to remain below trend for a considerable time.


• The volatility in all asset classes has reached extreme levels and is likely to persist for several months.


• However, at current valuations, equities in particular appear to offer the prospect of solid returns over a three-year holding period.

Lending conditions in economies all around the world were already tightening, and the events of recent weeks have exaggerated that trend. The main way this affects the economic outlook is through the household net savings rate (the amount private individuals save, minus what they borrow, expressed as a percentage of their income). In the short term, the key element of this equation is borrowing, as gross saving rates are much less cyclical than borrowing decisions.

“Lending conditions in economies all around the world were already tightening, and the events of recent weeks have exaggerated that trend.” ~

A model of the US household net savings rate points to only a moderate increase in savings in 2009, caused by the so-called wealth effect. With house and equity prices both declining, households feel less wealthy and their usual response is to save more (initially by borrowing less). However, during and after periods of financial strain such as the mid-1970s and early 1990s, the savings rate rises faster than can be explained by factors affecting households’ demand for credit. That’s because, during these periods, there is also an involuntary element to reduced borrowing, as banks tighten lending conditions, reducing or even cutting off credit to some households.

We have produced two projections for economic growth: one taking into account this sort of credit constraint on households, which is our central scenario; and one without, which represents the upside scenario and shows how economic growth would respond to any rapid easing of lending conditions. We can also map a third path for economic growth activity that is driven solely by lending conditions. In this downside scenario, we assume that the whole range of monetary and fiscal policies aimed at stimulating a recovery would prove totally ineffective. Of course, that looks unrealistic, but it allows us to quantify – and thus control – the risks such an outcome would present to our portfolios.

Since mid-2008, the equity market has moved from a position in which our upside scenario for earnings was priced in to one that is consistent with our central case or probably a little worse. Some downside risk remains, in that equity markets have not discounted the ‘worst of all worlds’, but a lot of bad news is already in the price.

A long-term analysis of valuations shows that, as a result of this pessimism on the part of investors, equities are now more attractively priced than at any time since May 1989. The chart of the price-earnings ratio (PE) for the S&P 500 using trailing 10-year average earnings shows valuations are low but still not at their cheapest ever levels – equities were cheaper during the depression of the 1930s, the stagflation of the 1970s and the two world wars.

“As a result of this pessimism on the part of investors, equities are now more attractively priced than at any time since May 1989.”

To conclude, the near term is clouded by high volatility. Yet to believe that equity returns would be negative over any period of more than three years would require an extreme and unrealistically bleak outlook for economic growth. So, for investors who feel able to withstand a bumpy ride in the near term, these are levels at which to consider gradually building up equity positions.

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