Market sell off – what now?

We are still, structurally, in a bull market. The risks of inflation resurging, or a ‘hard landing’ are low. Corporate earnings and equity valuations remain supportive (see ‘Value’ below). However, the technical position (see ‘Technical’ below) remains unclear.

Value. Pan European equity markets offer significant value and this underpins the case for equities on a 3-6m view. The FTSE 100 is now trading on 12.7x (‘06) and 11.9x (‘07), with a trailing dividend yield of 3.3%; the FTSE Eurofirst 300 is on 13x (‘06) and 12x (‘07), with a trailing yield of 2.8%. This compares to nominal bond yields of 4.5% in the UK and 3.9% in the €urozone, both down 20bps in the past week.

In terms of valuation support for the market, several sectors in the UK now offer prospective dividend yields in excess of gilts: Banks (4.8%), Utilities (4.8%), Telecoms (5.1%). Together these sectors account for 27% of the UK market.

From a short term perspective, it is likely that the S&P 500 will need to stabilise for 5-7 trading days before the market has bottomed. There are several indications of oversold conditions (Put/Call ratio, VIX) but an improvement in breadth is required for a sustainable rally.

So what has changed? The major change, in addition to the weak US$ and inflation fears, has been an increase in the global cost of capital as bond yields have moved higher in recent weeks. Whilst some of the rise has unwound this, and the sharp correction in equity prices after a long period of deceptively solid price rises, probably marks the beginning of a period of more sensitive risk appetite.

Technically speaking….. the FTSE 100 (up 126 as we write) was back to its nervous ways yesterday, dropping precipitously on fears that US markets would continue their recent descent. As it turned out, Wall Street did end yesterday’s session lower but was nowhere near as weak as UK traders had been fearing - and that fact alone has ensured that we got a nice bounce this morning. It is worth mentioning that Monday’s weakness took the leading index right down to test critical uptrend support and that means that the move higher today (if sustained) is going to look a lot like a positive reaction to the trendline. The bulls will be thinking ‘not before time’. The 14-day Relative Strength Index , for example, is almost as low as it was in March 2003 and that could mean that a technical rally is now due. 

However, expect this period of volatility to continue for longer than a few weeks. The next US FOMC meeting is on 29^th June and in the run up to this we are likely to see both good and bad data - along with volatility. To some extent the seeds of the solution to current nervousness are already sown, as Fed Chairman Benanke can tailor his policy (and words) to restore confidence. And eventually lower commodity prices will reduce some concerns about inflationary pressures.

What next? The current market correction (if that is what it is) has come as little surprise to many. Investor reaction to it will depend on individual circumstances; but many long term investors, backed by substantial global liquidity (still), will start to look for opportunities to buy into this fall (there is some evidence that this has already started but we believe it is still too early to make this call). LargeCaps, as anticipated, have fared relatively well and are likely to continue to outperform SmallCaps. Within emerging markets some will use the opportunity to buy countries with strong current account positions and reasonable valuations.

Bottom line: There is an awful lot of noise out there and, while this appears to be another period of correction after an unusually strong run, it is important not to be complacent. All of us are looking for important changes in fundamentals to justify a bear market and so far it is hard to identify any. Prima facie global market weakness should be used as an opportunity to add to portfolios – as with any period of panic selling – but we would keep some powder dry for the time being.

Prometheus from sources: ADM, Barclays Capital, Cazenove, Charles Stanley, HSBC, ING, SocGen, UBS.