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Value Amidst Volatility - Prudential Prutalk May 2008

Worst could be over...
Not sure if it is just us, but a whiff of optimism is in the air. After months of gloom, investors seem to be adopting the view (not without jitters) that the worst is over.

So are the markets turning a corner? There is no way to say for sure. In fact things could get uglier yet; there is still plenty of room for bad news. global economies, for example, must, at some point, react to the price of oil as it surges towards the $125 per barrel barrier. Yet, the way in which investors have embraced even the slightest bit of good news is hard to ignore. So let us get the bad news out of the way first.

The housing market remains in dreadful shape and the financials remain under duress. It is not a pretty picture. Yet Wall Street has powered ahead since early May pushing the S&P Composite index above 1,400 for the first time this year. Investors, amidst a chorus of claims, are clearly banking that the worst is over.

US Non-Financials results better than expected
It is easy to see why; March quarter US non-financial earnings rose over 10%. Of the 397 companies reporting (at the time of writing), 254 announced earnings up an average 20.4%. The other 115 reported falls averaging 36.9%. This, we think, is not a bad performance especially as we are six months into a US slowdown.

Even amongst the financials, it is too difficult to find good names that have been beaten down to rock bottom prices. The likes of Citibank come to mind. Its price to book value is less than half its average of the past 15 years. No wonder soverign funds have been taking advantage of market volatility to snap up opportunities. Target include financial companies embroiled in the credit turmoil. That fund managers see value is deniable. The bottom line: many stocks have been oversold to the point that they are too cheap to ignore. And that is the basic message in our chart above; even if the bears are right in insisting that the US economy is in parlous state, vluations are taking this into account.

"Honey Trap", scream the bears
they fret that the inevitable slide into recession will result in the much awaited burning of 2008 non-financial profits forecasts. Yet, in defiance, the analysts have recently begun upgrading their 12-month outlooks. If the bears are correct, the analysts are in denial to an unbelievable extent. Reality really will come as an awful shock if they are right. And early May's weak economic data keeps the door open to this possibility. Likewise, analysts anticipate that banks such as HSBC, will need to provision further debt until 2009.

So it is glib to argue that everyone is in denial. One can argue that US equities have already discounted 0% earnings growth in 2008; the consensus forecast is 16%. That is an awful lot of leeway. And equities are not the only asset class discounting a worst-case scenario.

Bonds are going cheap too
Many bonds are already trading at valuations that assume bankruptcy. the current default rate of 1.4% for the riskier high yield bonds, for example, is less than one-third the 20-year average of 4.3%. These bonds are attractively priced even considering the increased default risk in a weak economy. A similar picture is painted for US investment grade bonds by the wide credit spread. This was recently at near record highs.

As with equities, bond investors too are assuming that better times lie ahead. The 2-year benchmark Treasury yield recently rose above the US Fed Funds target rate for the first time since mid-2006. While the rise may be too early, it must be admitted that this market has had a good track record in anticipating future Fed moves.

Reits are equally affected
Yet another of the market downturn is the Real Estate Investment Trusts or Reits. In the wake of the US sub-prime crisis, collapsing US residential prices triggered widespread sell-offs in Reits globally. "What is so unusual about that?" one may ask. Nothing, except many Reits invest in commercial real estate that has mostly sidestepped the housing bloodbath.

Asian Reits, too, sold off despite strong fundamentals. Share prices of most regional Reits slid, compounded by the inability of Australian based Centro Properties, to refinance its short-term debt. That Centro's problems were purely company-specific was lost on panic-stricken investors. Though sentiment seems to be recovering, many Reits remain below their property values.

Is the US dollar discounting too?
Dare one say it out loud, but one can also make the case that the US dollar is grossly oversold; it is plumbing 38-year lows, measured against the major trading partners' currencies and adjusted for inflation.

Tweaking investor interest in the US dollar is the improvement in the "twin" deficits as a percentage of GDP forecast for 2009. Normally, movements in the twin deficits lead movements in the US dollar - with a long and variable time lag. Recently, however, it seems that the dollar has begun discounting the sharp deterioration in the US budget deficit forecast for 2008. In contrast, it has not discounted the forecast 2009 deficit recovery. If the US only flirts with a "pale" recession, as some allude, the case for a dollar rebound strengthens.

Are investors ahead of the curve?
After months of fear and uncertainty, greed seems to be taking over. The risk is that investors are reacting too early to the patchy good news that is emerging. But equally, much of the bad news already seems to have been discounted, which is possibly why investors have reacted so positively to good news. Furthermore, the sell-off seen since last October is but a fraction of the sell-offs that began in 2000 (also in 1997 in Asia).

The bears argue that this highlights the extent to which equities have yet to fall. But equities today are much cheaper than they were prior to the falls just highlighted. An awful lot of discounting has gone on. The bears could be correct. But the picture emerging is that even if they are, investors are ahead of the curve. They are well on the way to discounting an extended US recession, we believe. Anything less could well be a signal to buy.

Prudential sees value even though we retain our cautious attitude. We are selectively adding to Asian stocks that we like, but are not chasing the market. Attractive valuations exist in the US, while Europe is at rock-bottom prices. But uncertainty could drive these markets lower. We are braced for further volatility.
PruTalk, a monthly financial commentary, by Prudential Asset Management