Best to take long-term view regarding equity markets

May 26 2010 by Andrew Miller, The Journal

FEW things are certain in life, but one thing that is certain is that politicians retain the ability to take us all by surprise.

The equity market’s nerves were pretty frayed to begin with but their mood worsened last week as the German authorities announced a ban on naked short selling on a number of key companies and certain fixed interest investments (naked short selling is the practice of short-selling a financial instrument without first borrowing the security or at least ensuring that the security can be borrowed, as is usually done in a short sale). This was a surprising decision, particularly as it was undertaken unilaterally, without consultation with other European governments.

Unsurprisingly, equity markets haven’t reacted well to this latest piece of legislation. A mixture of suspicion and fear has sent indices lower and back to within touching distance of 2010’s lows. Worryingly, this hasn’t been contained to Europe – the US indices have also sold off sharply, taking year-to-date returns dangerously close to negative territory.

The US financial sector was also hit hard by domestic developments as the US Senate approved the financial reform bill, the largest reform of financial regulation since the 1930s. The bill may still face minor amendments before it becomes law, but the overall message is that the operating environment will become tougher for the banking sector.

The fact that this legislation – the details of which were very widely known – resulted in a sell-off shows how nervous investors are currently. Closer to home, the action taken by Germany has also served as a reminder that tougher financial regulation is coming in Europe too.

So, how should investors approach the equity markets in the current environment? The first thing we would say is that given the currently high levels of uncertainty, now is still not the time to be making brave short-term decisions. Indeed, in our view, the most sensible tactic for risk-averse investors is to wait for the financial fog to clear.

However, as with every threat there is an opportunity, and the opportunity in this case is that the recent sell-off means that some equity markets are looking cheap again. Of course, as is usually the case, there are some areas of the market that look more attractive than others. Financials may look cheap on paper, but they are cheap for a reason – they remain at the forefront of market concerns, which range from worries about their exposure to sovereign debt to the spectre of increased regulation.

Balancing the positives and negatives leads us to conclude that a neutral position is appropriate here.

Elsewhere in the market there are plenty of sectors that offer strong cash flows, improving profitability, and recovering revenues – industrials and IT are our two favoured sectors in this regard, but telecoms and oils also offer a similar profile.

We are underweight in the materials and consumer discretionary stocks, as we expect more volatility here.

So overall, we remain constructive towards equities, especially when taking a long-term (12 monthS or more) view. However, we need to be increasingly sensitive to market nervousness – that is why we are adopting some caution and advocate sitting tight on a short-term or tactical basis: unfortunately, the current volatility in equity markets is unlikely to subside overnight.

Andrew Miller is regional office head of Barclays Wealth