Not long ago, it seemed like investors wouldn't touch equities with a 10-foot pole. With the recent run-up in the market both domestically and in Europe, that may be changing.
As the news becomes progressively less gloomy, big investors are beginning to show a greater appetite for risk and are wading back into European equities.
According to Christopher Potts, head of economics and strategy at European broker CA Cheuvreux, the period of imbalance in portfolios -- the "run for the exits" -- has given way to more normalized portfolios with normalized exposure to equity. "We are not telling long-term investors to move from extreme security to extreme risk and value," Potts said. "We have simply been saying that they should have a more normal portfolio."
Potts says Cheuvreux has steadily raised its exposure to the higher risk euro-zone equity markets within developed Europe, noting that they have "returned to a more balanced sector and market asset allocation in which we are taking advantage of long-term value."
Breaking down the turning points
First, he points out that fundamentals have helped fuel this rally. For instance, the ratio of new manufacturing orders to inventor has spiked since its lows in December.
Second, according to Potts, precedent suggests that it requires close to three years for equity markets to fully absorb a major shock of the magnitude with which the world is coping. "It is apparent to us that financial de-leveraging has accelerated the speed of adjustment in the current cycle," he said.
Third, investors should examine the health of the credit markets for a guide to equity market performance. Potts says the crucial turning point will be when the "risk-free" return linked to government securities becomes higher.
He also points out that we cannot see sustained recovery of the cheapest, most distressed stocks without evidence of demand for high-yielding corporate bonds -- and that may be changing. $600 billion worth of corporate bonds were sold in Europe during the first quarter, a whopping 60% increase from the same period last year. The question is, with a muddled economic outlook, will investors continue to pile into corporates?
In other words, is this trend sustainable? Only time will tell.
And fourth, the turning point for European equities may be closer than we think. "Europe's historic P/E has once again come close to moving below its dividend yield," according to Adrian Cattley, European Equity Strategist at Citigroup
Translation: Valuations on even the strongest companies are low and could be good buys.
So is this the real deal?
European equities have staged a 17% run since March 3. But is it the beginning of a new, sustainable bull -- or merely a bear-market rally?
To the European equity experts I interviewed, it's looking more like the latter. The fundamentals are becoming less, well, crummy, but the recovery process is only just budding and remains rocky. The sheer speed of the rally itself would indicate that as well.
When asked if the market revival is sustainable, Potts responded, "If sustainable means a fairly regular pattern of positive returns quarter after quarter then the answer is 'no.' But if the question is whether this recovery will be entirely reversed then the answer is also 'no.' We assume that the subsequent revival would probably be erratic, subject to frequent reversals."
Translation: All this said, volatility, and thus risk, although down from the record levels of 2008, remains extraordinarily high and markets will not behave "normally" in this context.
Don't wait for the "official" turning points
For investors with longer time horizons, bear-market rallies don't matter as much. Potts points out (and I absolutely agree) that investors would do well to remember that at "authentic turning points there is never much visible evidence to support a change in market behavior."
"It has become obvious that equity markets have begun to discount the beginning of the end-of-the-world super-recession, starting with the U.S. economy and China," he said.
Wise words for a new frontier
We're not off to the races yet, though. Potts highlights the broad recognition that 2009 will be a difficult year of great economic distress. He also notes that a consensus is emerging that sustained expansion in the world economy will not resume before 2010.
Risk remains high. But long-term investors should consider jumping in to take advantage of favorable valuations on quality businesses. Remember the stock market leads the underlying economic recovery. Don't wait until the writing is on the wall -- you may miss the party.
With that in mind, a cardinal rule of new bull markets is that the industries that led the past bull run will not lead the next. Potts says we're not going to see the return of smaller-cap value within developed equity markets or of the global growth-commodity theme.
"The conditions of cheap credit and financial super-leverage that allowed their supremacy are gone," he said.
"The world that will emerge from the wreckage of 2008-2009 promises to be more than usually different from its predecessor." Banks, for instance, won't offer the same returns to investors, as they did during the past cycle, which was characterized by the "golden" era of banking.
To get started, look for names with sustainable business models; I'll start you with a few ideas for further research:
- Netherlands-based consumer goods company Unilever
(NYSE:UN) . - Supermarket operator Morrison Supermarket.
- Mobile telecom titan Vodafone
(NYSE:VOD) , which has a strong balance sheet and stable business. - Mobile phone behemoth, Nokia
(NYSE:NOK) , which has a sustainable and scalable business model. - Pharmaceutical companies GlaxoSmithKline
(NYSE:GSK) and Novartis(NYSE:NVS) , which have diversified revenue streams.
The big institutions seem to be warming back up to European stocks. Are you more intrigued by international plays or opportunities right here in the States? Let us know by using the comments section below.
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