A revered Spanish novelist once wrote: "Take care, your worship, those things over there are not giants but windmills."
Well, there seem to be a few giant problems on the horizon! Real estate difficulties, stagflation, current account imbalances and sub prime problems to name but a few.
Some predictions for the future of house prices and equity values are downright ugly and that made me think of Sancho Panza’s warning to Don Quixote – we sometimes run scared of the benign.
Sure, the real estate boom is over. Its demise started in the US and is now spreading to other boom areas such as Ireland, Spain and the UK. Supply-side problems in UK housing will help to support domestic values.
Nevertheless, UK house prices will not rise significantly over the next twelve months and may actually decline by 1% or 2%. We do not, however, envisage the level of sensational free-fall that is being predicted by some commentators.
We remain very wary of the fixed interest market as we just cannot get excited about returns at around 4.4% on 30 year UK gilts. The reward for long-term investing in fixed interest simply seems to have dissipated.
Conversely, we like equities, particularly large-cap stocks in the main markets. PERs (Price Earnings Ratios – the number of times a company’s profits can be divided into its stockmarket value) are very low by historical levels. This view may seem strange when uncertainty abounds regarding the eventual fall-out from the sub-prime market debacle.
Bear in mind, however, that stockmarket valuations are based on forward looking projections and the difficulties with the sub-prime sector have already been absorbed, to a large extent, in banks’ share prices. As an example, from January to November 2007 the S&P 500 Index appreciated by just under 6%. During the same period US bank stocks depreciated, on average, by around 22%.
The IMF (International Monetary Fund) estimates potential losses on sub-prime mortgages at around $171 billion, which is just 1.97% of the entire US mortgage market.
The decline in US bank share values from January to November 2007 is around $270 billion, so a lot of the bad news has already been factored-in to market prices.
As Mervyn King described it in his recent testimony to the UK Parliament’s Treasury Select Committee, the potential sub-prime losses are equivalent to “...a bad day on the US stockmarket”.
Of course, the IMF may have underestimated the potential losses, but then again they are not all owned by the US banks. European banks have a share of the market as do other investors, such as hedge funds and institutions.
Overall, the above, together with current valuations, give us cause to believe that equity values at these levels are attractive on a three year view and we think they may surprise on the upside during 2008. Happy new year everyone – and be careful you don’t make giants out of windmills!
Gary Reynolds is director and chief investment officer at Courtiers
The views expressed in this article are those of its author and do not necessarily represent those of IFAonline or any other Incisive Media affiliated organisation.IFAonline
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