Yesterday the following two emails came in from clients 35 minutes apart:-
Client A - We are now in a position to take up our annual ration of ISAs for 2007/08. It seems a good time to invest, with stock market prices slipping, so would you please let us have your recommendations and organise the paperwork.
Client B - I do apologise for not getting back to you sooner, but the money I mentioned has only just gone into my account. However, given the turmoil in the market at the moment, I feel that it might not be such a good time to make a large investment and was wondering whether it would be better to leave it in an high interest account 6.3% for a while until things become clearer and make the investments later.
I would imagine that quite a lot of you reading this will be firmly in client B’s camp, and it is possibly worth pointing out that client A and his wife are in their late 70’s and client B is in his early 60’s. So what has got us to the stage where client A sees the current market conditions as a buying opportunity, and client B as an area to be avoided at present?
It is probably worth looking back over the events of the last seven or so months to see whether they can give us an indication of the future outlook. The main culprit is what I will call the “sub-prime virus”.
You will probably all have heard of “sub-prime” borrowing, and the impact this has had. This was a case of Banks, mainly in the US, lending money to people who they knew were a high credit risk, to buy their homes. In their wisdom the banks didn’t regard this as too high a risk as everyone knows that “property only goes up” and if they defaulted the bank would be left with a property worth more than the amount borrowed. Oops! Anyway the banks decided that they would package these “sub-prime” loans up with other less risky debt and sell them to other banks throughout the world. The other banks were keen to buy them as the interest paid was higher than normal rates and allowed them to make greater profits. Northern Rock was a particularly willing participant.
As house prices in certain parts of the US started to fall, and more and more of the borrowers found that they couldn’t make the payments, the number of defaults rose. However, unlike when this has happened in the past (this is not a new event) it wasn’t only the local banks that had a problem, but most banks throughout the world. However, as the “bad” debt was packaged up with other loans, banks found it virtually impossible to work out their liability. As a result banks became far less willing to lend money which led to the “credit crunch”.
As banks were unable to fully quantify their potential exposure to the sub-prime problem, the price of bank shares fell dramatically. A further knock-on effect of the credit crunch was the impact it had on share prices in mid and small cap markets which have also fallen substantially, as takeovers and mergers either between companies, or from what is known as Private Equity, has ground to a halt. In general these markets are down roughly 20% as a result. Large cap markets, and by that I mean the FTSE100 index in the UK are down roughly 10%. This means that anyone investing in the last year will probably find their investments will be down, and is the reason we remind clients that these investments must be viewed over the longer term.
The “sub-prime virus” has continued to mutate feeding off the bad news (which is readily reported) generated by the above events, and it is now threatening to develop into a recession. It is this fear that has created the wild swings in prices we are seeing on a daily basis in stockmarkets throughout the world. The prices are falling, not because of bad news that is being reported, but purely by fear. In many ways it reminds me of the autumn of 2002, where as a result of the Enron scandal, which to remind you was a case of companies not being particularly honest with its accounts, share prices in all companies, good or bad, were slashed. With hindsight, was that a good time to invest? – absolutely. Was it the right time to get out of the market and stay in cash? – no. Was it a time when we had new clients knocking our door down wanting to invest in the stockmarket because it was cheap? – nope!
Anyway, enough about 2002 – what is more important is today and what is likely to happen in the coming few years.
Well firstly, we can be pretty sure that when the dust settles on the sub-prime problem, we will find that the write-downs the banks have made in the last six months will be seen to have been exaggerated. The reason I can be pretty confident of this is twofold. Firstly as a result of the Enron scandal that I mentioned earlier, companies are now whiter than white when it comes to accounts reporting, as in the US failure to do so will result in the CEO and other board members breaking rocks, or working on the chain gang for quite a number of years. Therefore, given the inability of banks to be certain of their liabilities, we expect that most will have erred on the side of caution. Secondly, the properties that these loans were secured upon will be sold, probably at a knock down price, but something, whether it be 50p in the pound or more, will go back onto the bank balance sheet. Remember these are write downs, not write offs, that we have been hearing about.
Also unlike medical viruses which are impervious to antibiotics, the “sub-prime virus” could easily be killed off with interest rate cuts. However, like medical treatment, the longer that it takes to administer the drug the more aggressive treatment needs to be once it starts, so if we don’t start seeing cuts soon, it is likely that we will have to have significant cuts before the summer. However, once the market sees signs that the virus is under control, and the credit crunch starts to unwind, it is likely that takeovers and mergers will reappear on the horizon. This in turn should lead to an upturn in share prices, particularly in the sectors that have been hardest hit, and when this happens we could see a further significant spike in share prices, as hedge funds which have been selling stocks as the markets have fallen will become forced buyers to limit their losses.
When will this happen? I have no idea, and neither does anyone else, but it does seem the likely outcome, as unlike medical viruses, we know what has caused this problem and we also know the treatment. What I do know however, is that it is not a time to panic, and indeed assuming you have a long timescale that you are prepared to view investments over it is probably an ideal time to put more in.
One final thought, which may bring comfort, in previous recessions (and the last one wasn’t even reported until it was over) the stockmarket in the UK has risen by an average of 3%! Perverse but true.
Steven Forbes
Managing Director
Friday, 18 January 2008.
