Although forced selling of stocks by insurance companies means there are real bargains to be had, overall returns are likely to be subdued over the medium term
Against the uncertain geopolitical backdrop, economic and corporate news has often been better than expected. However, this was largely ignored by investors, who sought safety in traditional safe havens such as government bonds and gold.
The FTSE All-Share has underperformed global markets mainly because life insurance companies in the UK invest a significantly higher proportion of their assets in equities compared to their US (and, to a lesser extent, European) counterparts. This led, declining equity markets to erode their capital more severely. Some were forced to reduce their equity exposure in favour of lower-risk government bonds to protect their statutory solvency ratios, driving equities lower still, precipitating another wave of selling, and so on.
What this means is that many UK equities are now mispriced, and there are some incredible bargains to be had. Some 100 of the largest 150 stocks offer prospective dividend yields higher than 10-year government bonds and cash and the FTSE All-Share index overall, which is trading on 12 times 2003 earnings, yields marginally less than 4%. Of course, this needs to be qualified: some of the market's dividend income may not be there in a year's time, and if you calculate the market valuation by adding back goodwill (especially from Vodafone), it is trading on a multiple closer to 14 times 2003 earnings.
However, I really do believe that these are very interesting times to be looking at the UK market. Why would you sell an asset class yielding 4%, where that income could grow on an annual basis, and invest instead in a competing asset class (bonds) where the 4% coupon is fixed for the life of the investment? The answer, of course, lies in investors' concerns about companies' solvency and their tolerance for risk ' but I think it illustrates how extreme the situation has become.
What is missing is a catalyst ' there are still too many questions without easy answers to encourage investors to look beyond the immediate uncertainty. What is going to end the forced selling? Who is the marginal buyer of UK equities? Can the situation in Iraq be resolved successfully from a Western perspective? Is there any chance of economic growth accelerating again?
One positive development occurred at the end of January, however, ' the FSA, which estimated that life companies have sold £20bn to £25bn of shares in the past 18 months, said that it would relax its solvency rules. This was clearly a step in the right direction to break that vicious cycle. In any case, the FSA said, within the past two years, with-profits funds' average weighting in global equities has already fallen to 37% from 75%, suggesting we could be nearing the end of the process anyway.
Other factors should also give investors encouragement. There are positive signs from buyers although none of these come from the traditional investor bases. Retail investors are not buying, institutional investors cannot buy, and overseas investors have not increased their exposure to the UK market for two years but companies and private equity investors are stepping in. Not only is the ratio of directors' purchases to sales already very high, I expect a plethora of well-capitalised, large companies to announce share buybacks after the current results season if the market remains at such low levels.
In addition, the private equity sector has been snapping up cash-generative companies at extremely attractive valuations.
The fact there are six bidders for food retailer Safeway in this environment, when money is cheap and valuations are so low, is no accident. Although you can argue that such opportunistic bids do not benefit the wider market (only the target company's shareholders), I think there is a lot more of this to come.
I find it more difficult to make sweeping judgements on some of the other issues.
On economic growth, I have certainly become more wary about how resilient the UK consumer ' assailed by headlines of war and plunging markets and about to endure higher National Insurance contributions ' will be. Although robust housing prices and low unemployment should provide some support, companies in sectors such as retail, pubs and leisure are no longer the safe havens they were during 2000-01.
I still believe that the US economy will continue to recover sluggishly, aided by government spending despite no additional impetus from investment spending or consumers (who are likely to save more and spend less). Unfortunately, it remains easier to hypothesise a recession than a case for strong growth, and it is all too easy to identify the structural concerns surrounding the US economy (high consumer and corporate debt levels, ballooning budget deficit).
Consequently, no matter how oversold I think the UK market is, I have not changed my view that the equity returns are likely to be subdued over the medium term, and that an aggressive pro-cyclical stance on the basis of a strong economic recovery remains inappropriate. That said, I am still optimistic about overall prospects for equity markets from these levels, and have increased my exposure to the two areas I feel are most mispriced. These are selected large-cap stocks (which, because of their greater liquidity, suffered disproportionately from insurers' forced selling) and companies offering stable earnings growth and reasonable visibility.
Forced selling by insurance companies has led to many UK equities being mispriced.
Companies and private equity investors are stepping into the breach to buy undervalued shares.
Equity returns are likely to be subdued for the medium term but firms offering stable earnings growth are well placed.
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