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Is the bear market over?

Was 6 March the end of the stock market slump and the day
things started to improve? It’s a question keeping financial blogs buzzing and
equity strategists pumping out analyst notes by the metre.

Since that date, financial markets on either side of the Atlantic have
trended gradually upwards, with the FTSE-100 adding 10% and the S&P 500
adding 19% by mid-April. Predicting the top and the bottom of equity markets is
notoriously tricky and this was no exception.

Andrew Wilson, head of investment at Towry Law, said, “Nobody predicted that
we were approaching the bottom of the equity market, no one said on the day
‘that was the bottom of the market’ and afterwards no one said ‘that was the
bottom of the market’. That makes me think that it could, indeed, have been the
bottom of the market.”

Follow the evidence
But there is other evidence that 6 March marked a turning point in the equity
market. Investment professionals know that flows in retail mutual funds are
usually excellent contra-indicators: inflows reach their peak at the top of the
market and when the level of redemptions reaches flood proportions, it’s usually
a good sign that the market has reached its bottom.

“In the week leading up to 6 March, the number of withdrawals from
equity-based vehicles in the US rose to a staggering $30bn, indicating investor
capitulation, giving some hope that this could be the bottom of the current
crisis,” says Wilson.

While mutual fund flows may be an excellent indicator of investor sentiment,
there are more solid fundamental reasons to believe that the outlook for the
financial markets may be starting to recover.

Economic data has been slightly more optimistic in recent weeks (see other
story, this page). As Vicky Redwood, economist at Capital Economics, said, “The
good news is that the sharpest contraction in output is behind us, but the bad
news is we are still a long way from the economy expanding again.”

Equities bottom out
While the economic data may start to be bad rather than terrible, and the
outlook will continue to be very difficult for most companies, some believe we
have seen the bottom of the equity market.

“This is the bottom of the equity market,” said Mitchell Fraser-Jones,
product director of UK equities at Invesco Perpetual. “Equity markets are based
on future rather than current economic performance and while the economic
backdrop will remain challenged for some time, probably several years, the
market already reflects this difficult scenario through extremely low
valuations.”

The composition of the FTSE-100 should also help the index to perform better
than the UK’s domestic economy in coming months. “A significant proportion of
the constituents of the FTSE-100 are defensive companies that have strong
balance sheets and are not over-exposed to the domestic economy. Oil,
pharmaceuticals, utility, telecom and tobacco companies make up around half of
the index,” said Fraser-Jones.

This does not mean investors and FDs can relax. Uncertainty still abounds.

“Many companies are finding it impossible to accurately predict their
revenues and profits over the next 12 to 18 months, so there are bound to be
more unexpected profit warnings and companies cutting their dividends,” says
Fraser-Jones.

This inability to predict future earnings will translate into continued
market volatility.

“There is likely to continue to be some stomach-turning drops along the way,
but based on previous performance of the equity markets recovering from
recessions, over the longer term, it will make sense to have money invested in
the market,” said Wilson.

But for FDs trying to steer their company through recession, does this more
positive outlook for the equity market mean a sunny outlook for their share
price and an opening up of financing opportunities?

There are indeed signs that some of the hope surrounding the equity market is
reflected at an individual company level and that, although life continues to be
tough, the outlook is no longer terrible.

Deloitte’s most recent quarterly FD survey finds the Bank of England’s deep
cuts to the cost of borrowing have begun to have some impact and that credit
conditions have improved slightly.
But FDs have only been able to profit from cheaper borrowing by reducing the
cost of existing corporate debt. It has, as yet, had little impact on the
availability or cost of new credit.

FDs are still smarting from the aftershocks of the credit crunch and, after
years of plenty, are shunning debt whether in the form of corporate bonds or
bank borrowing.

Ian Stewart, chief economist at Deloitte, says, “Most finance directors think
company balance sheets are overleveraged and most plan to reduce the debt levels
of their own balance sheets over the next year. This was the first of the seven
quarterly surveys that we have conducted where FDs said equity was a more
attractive form of financing than debt.”

Those companies, however, whose balance sheets are in good shape and have a
business model that is able to survive the recession, would find considerable
investor appetite for their corporate bonds.

“We are not averse to seeing a relatively high level of debt in any of the
companies that we invest in,” says Fraser-Jones, “as long as they have a
resilient business model that can withstand the recession. If companies need to
raise capital, we would generally prefer to see debt issued rather than equity
that would dilute our ownership of the business.”

There has been a rising level of interest in investment grade corporate bonds
with the growing consensus that pricing in the corporate bond reflects a lack of
liquidity rather than an accurate reflection of the real levels of corporate
default.

“There is increasing noise from fund managers and independent financial
advisers that corporate bonds are an excellent investment opportunity. I’d agree
with that, but with the caveat that it’s a medium to long-term investment,” says
Towry Law’s Wilson.

The Deloitte survey points out, however, that while most FDs may prefer the
idea of equity rather than debt, appetite for debt or equity issuance remains at
low levels and the minds of FDs are firmly focused on cost cutting, including
reducing employee headcount.

There is also a growing appetite for cutting dividends: 30% of FDs say they
have, or are planning to, cut dividends – a ten-fold increase on a year ago.

FDs’ willingness to contemplate reducing dividend payouts is a clear
reflection of just how tough life continues to be for companies. This
uncertainty means that while there is a growing consensus that the worst is
over, it’s not a universally held view.

“We talk to a range of fund managers and there is a gamut of views from the
optimistic to the extremely pessimistic,” said Wilson.

The message for FDs is clear: there maybe light at the end of the tunnel, but
it is, as yet, only a pinprick. They can’t afford to relax just yet.

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