Markets and economies in for a long, slow haul to recovery

Friday 28th September 2001

Belt-tightening has emerged as the key theme for investors. With threats of war thickening the air, people are likely to head to the bunkers until the air-raid sirens stop howling.

In keeping with the times, US war bonds have emerged as the ultimate defensive investment. Markets and economies are likely to be in for a long, slow haul to restore their previous positions before the dot bomb crash, assuming that they are ever likely to be able to do so.

It should be recollected that the tech craze was a one-off mania that inflated stocks well beyond reasonable return expectations. The effect was exacerbated by ramping of telecommunication company share prices due to overexpectation of what was possible with 3G spectra.

Those expectations met with a rude awakening before terrorist raids on American soil.

The next mania in stocks may be a long time coming. The present hammering taken by sharemarkets is exaggerated by the combination of a mania peak, hit in March 2000, followed by a selldown that World War III, starting September 2001, will deepen and accelerate.

Recent rallies in shares have inspired hope that the bottom is near but there were false rallies during the 17-month bear market caused by the tech wreck.

Periods of uplift will most likely deceive until fundamentals are restored.

A recent edition of the Economist, published just before the attacks, argued price/ earning ratios on stocks in the S&P 500 index were still grossly inflated at an average 23 to 37, depending on the measurement standard and that they were due to return to long-term trend values of 14 to 18.

The magazine argued such a rectification would imply a 40% fall of the S&P 500 as at values pre-assault.

One effect the attacks and their aftermath is likely to have is that the return to target p/e's will probably take place more quickly than otherwise.

The signal that the bottom has been reached could be resumption by average p/e's of the 14 to 18 band.

The suicide bombers may have brought forward the day of reckoning for equities.

What can be salvaged from sharemarkets at this time? Defensive investments in sectors such as retail, pharmaceuticals and utilities may appeal but these are likely to be fully priced already as investors have switched into them.

Telecommunications, ironically enough considering their 3G trashing, may be an undervalued defensive sector but debt levels of such companies would need to be looked at closely. Companies with a manufacturing exposure that might benefit from increased military spending might be a punt.

Even airlines, the strongest ones, and related industries such as hotels, could be a clever move for the longer-term players.

Travel and tourism will be hit hard by the wave of fear and apprehension gripping consumers, and business travel was slumping even before the bombings occurred as companies retrenched. But at some stage these sectors will turn around again.

One possibility is short-selling stocks as hedge funds do. Hedge funds are building up a potential new mania on the basis that they can profit in falling markets.

The Economist has expressed disquiet at the US hedge fund boom now under way. Some of these funds will come unstuck badly.

It will be necessary to choose such investments judiciously, looking closely at track record, manager qualification and achievement, investment style and the types of markets invested across.

Good-quality hedge funds offer a way to salvage something from the equities sell-off.

Looking further ahead, baby boomers will still need to save for their retirement and over the longer run shares are best likely to achieve the best overall compounding rates of return. So their money will return to the market.

However, rates of return from shares may well be lower in future than previously expected, not because of a war situation, which will one day end, but of more fundamental significance the achievement of permanent low inflation.

In response, retirement savers will need to put aside more savings than before to achieve needed end capital sums, which should restore some lustre to shares as investment inflows are restored.

While shares attract most attention now in terms of poor general performance, the next major market of focus will be bonds.

Emergency measures in low interest rates and huge increases in cash liquidity by central banks are laying the foundation for tighter liquidity and higher interest rates later on to resume anti-inflationary effects. Under such conditions, bonds will take a hit.

If this is so, the hedge funds may have a longer run to go, once they are perceived as having a use to counter weakness not just in sharemarkets, but in bond markets as well.

The most conservative investors, however, will still look to cash as a safe haven, and the trusty mattress may make a comeback as a place to store wealth.

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