Opportunity knocks for savvy investors

Oct 22 2008 by Andrew Miller for The Journal

THE word ‘unprecedented’ has been used more often than any other adjective to describe the events of the last seven weeks. And rightly so.

We believe that the past several weeks have created unprecedented investing opportunities. Most important is diversification. Wealth creation and preservation is a long game.

Private investors, almost uniquely in the world (along with sovereign wealth funds and investors like Warren Buffett), can take advantage of dislocations in the markets we see today.

By contrast, banks, insurance companies, pensions and hedge funds must worry about tomorrow’s mark to market, not the inherent value of securities. Forced selling by the latter have created some good opportunities for the former.

The case for equities

Firstly, equity valuations are low. As Tim Bond from Barclays Capital points out, valuations as measured by trailing price/earnings (PE) ratios are at once-in-a-generation lows. When PE ratios get stretched this far, Barclays Capital finds that the following 12-month returns are almost always above 10%. Secondly, the world’s central banks are creating liquidity (money) at an unprecedented rate. This has two benefits. It reduces stasis in the money markets and helps them function. And over time, the money reflates asset prices.

Thirdly, momentum will eventually turn in markets’ favour. This might seem strange. Negative momentum has brought markets to five-year lows in a matter of weeks – how can momentum be a positive for stocks now? But momentum is a bit like a hurricane. Eventually, it exhausts itself. Markets can’t stay negative forever.

And finally, policymakers are now much more adept in the art and science of financial crisis management. As in the private sector, mistakes have been made along the way, but the public sector is now getting the response mostly right.

The risks

By nationalising the liabilities of some of the major banks of Europe and by taking seats on their boards, governments have gained considerably more power over the allocation of credit in society.

If governments can resist the temptation to make state-directed lending decisions, then economic growth will return and the bank rescue will be hailed as a massive success.

But if governments favour selected groups rather than acting as profit-maximisers, then capitalism as we know it, 141 years after the publication of Das Kapital, is over. This is the risk.

Where to invest?

Stocks are cheap, as discussed above, but substantial risks remain, primarily around state intervention in lending. Markets aren’t likely to rise straight from here; the damage is too severe. We expect equities to be very choppy in the short run, but not fall much further from here.

For those who are sitting in cash and waiting for an entry point, we suggest a programme of methodical buying over the next few quarters. For those who have held on to their stocks through this turbulent period, now is not the time to panic.

Fixed income also presents a buying opportunity in the corporate bond space. Unless we enter a major depression (possible but not at all likely) then switching out of government bonds and into a diversified portfolio makes excellent sense for many.

And for the first time in years, inflation-linked bonds offer excellent value – another example of distressed selling.

Currencies have also been turbulent of late.

While in the short term, the dollar may give back some of its recent gains, we expect it to strengthen modestly in 2009.

But euro and the pound will suffer some political risk and a deteriorating interest rate position in 2009.

Focus on the long term

These past few weeks have been among the most tumultuous in financial history. There were some days it felt like the world was coming to an end. But it wasn’t. And it isn’t.

As long as the bailout package recapitalises banks, allows for the re-liquification of the markets and lets the system heal itself, the world will recover fine through a soft economic patch over the next few years.

If policymakers avoid errors as they direct capital from their newly-owned banks, capitalism will prevail – and savvy investors should enjoy excellent returns in the coming years from investments made during these dark days.

Andrew Miller is regional office head of Barclays Wealth