Buy quality and hold your nerve

By Tim Price Dec 12, 2008

Tim Price

Print this article

Markets create opinions, rather than the other way round. That may sound strange to followers of the efficient-market hypothesis (if there are any left), but it's true. Markets have also acted in time-honoured fashion this year and admirably performed their role of discounting the future. The reversals of fortune have been stunning. The S&P 500 index has fallen by 40% – its steepest decline since 1931. The MSCI World Equity Index has fallen by 45%, its sharpest fall since its inception in 1970. It is now left to the broader economy to play catch-up and to deliver what markets have been signalling since the credit markets first imploded in summer 2007.

The Great Moderation is over. What lies ahead is even harder than usual to forecast. Try asking company executives their views of the future and you will hear only that there is a chronic lack of 'visibility'. Government-bond markets are pricing in something between recession and depression, together with a long-lived collapse in inflation. Corporate bonds are pricing in a devastating rise in company defaults. Stockmarkets are pricing in Armageddon. But unlike gilts, credit default swaps (CDS) or eurobonds, the stockmarket isn't entirely convinced, as the violent ups and downs of recent weeks would tend to suggest. While there have been innumerable false dawns of recovery during the Great Crash of 2008, the price action in stockmarkets that greeted last Friday's US non-farm payrolls data was, even by the standards of a remarkable year, utterly extraordinary.

US employers cut staff at the fastest rate in 34 years. The unemployment rate rose to a 15-year high. Over 530,000 workers lost their jobs in November. Financial services losses were the worst in the 60-year history of the survey. And how did the US equity market react to this carpet bombing of bad news? It rallied by 7% from its lows for the day.

It's often said that bear markets end when the market stops going down on bad news. It's too early to tell, but that is certainly what it did last week. There was evidently some support lurking in the wings for President-elect Barack Obama's infrastructure investment plans. But whatever the reason for the bounce, the market was determined to rally.

It's almost as if we are living through a repeat of the 1930s, but on extreme fast forward. The Dow Jones fell by roughly 48% from its high during 1929. It then proceeded to mark lower highs and lower lows until its ignominious trough in 1932. President Franklin Delano Roosevelt didn't take office until March 1933, whereupon his "First 100 Days" saw a flurry of pump-priming bills sent to Congress. This time round, Obama hasn't even taken office, and he has already telegraphed clear proposals for investment in roads, bridges, internet infrastructure, healthcare and schools.

So we can hardly fault today's governments for their determination to support the banks – having learned the painful lessons from the 1930s on what happens when you let them fail – and forestall the forces of deflation. But be careful what you wish for. Throwing everything including the kitchen sink at a deflationary credit crisis has shored up a degree of confidence in the banking sector, but at what cost? Future taxpayers will find out. So will holders of conventional gilts. Current savers are already finding out, and they are unlikely to appreciate what cash deposit rates are telling them. And holders of sterling already know, too.

There is a tendency for banking crises to turn into full-blown currency crises as they evolve. Since the banking crisis was international in scope, the chances are that the currency impact will be felt across several borders too. So while the US dollar has been the technical beneficiary of deleveraging as investors bring their assets 'home' to the global reserve currency, time will tell whether the fundamentals of the US economy, in particular its growing indebtedness to foreign strangers, really warrant such safe-haven status for the greenback.

Probably the most frustrating characteristic of the investment markets in 2008 has been the tendency of pretty much all financial assets to fall at the same time. What may be equally frustrating as stockmarkets nervously try and register their lows is assessing which assets will act as a store of value, let alone benefit, from what is to come. The unprecedented reflationary efforts of the world's central banks are unlikely to be sterilised away. Government bonds seem unconvinced that all those billions of dollars, pounds and euros will have any chance of inflating back the real economy. Equity markets are trying to point to recovery, even as we enter into what will likely be a peculiarly bloody recession. The answer is probably to focus on high-quality equities and bonds, but holding one's nerve in the face of bad news flow is going to be a challenge.

• Tim Price is director of investment at PFP Wealth Management. He also edits The Price Report investment newsletter.

Published in Stock markets | More articles by Tim Price

Related articles