2008 in summary: A year to remember

The events of the last year made the inputs to our models much more volatile than normal, but they have also created large opportunities. We can describe the events over the last year as having three major themes, evidence of which started in 2007, before becoming more pronounced in 2008. These include a significant increase in investor risk aversion, an economic slowdown and deleveraging.

Increased risk aversion

Investor risk aversion for all types of assets increased throughout the year. This can be seen by falling P/E ratios for stocks, widening spreads for corporate bonds, and most measures of investor sentiment well above normal levels. Cycles of risk aversion are a normal part of markets. However, this time the cycle has been deeper and longer than typical. As a result of the fall-out from the sub-prime crisis and falling security prices, investors were more risk averse than normal at the start of 2008. As the year progressed, the situation became worse and investors' fears increased. Similarities between the current situation in the US and Japan at the end of the 1980s such as the real estate bubble and developing credit crunch raised fears that the US could be facing a situation similar to Japan's 'lost decade'. The failure of Northern Rock in the UK and Bear Stearns in the US were symptomatic of the problems, and the events also worsened the credit crunch. The failure of Lehman Brothers was the trigger that turned it into a global credit crisis. However, subsequent global fiscal and monetary actions as well as capital injections into the banking systems and other policy actions have started to loosen the credit markets. While we do not minimise the risks of the current environment, once investors start to look past the bad news, we expect to see a sharp and sustained rally in stock markets worldwide.

Deleveraging

The second theme is one of investor and corporate deleveraging in which stocks and other risky assets were sold, thus driving down their prices. The deleveraging had a number of causes. Increased asset volatility led investors to delever in order to maintain their desired risk levels. Poor investment performance by hedge funds and others caused them to reduce positions in order to reduce risk. Lastly, the credit crunch caused some to delever simply due to their inability to secure the borrowing required to support their positions. However, deleveraging will run its course, and once the cycle ends, it should reduce the pressure on asset prices, and let them rise to their fair value.

Economic slowdown

Most agree that as a result of the sub-prime crisis and falling real estate prices the global economy started to slow last year. This year the slowdown accelerated, and the consensus is that we are facing a global recession. This lowers corporate earnings, which in turn lowers stocks' values. However, prices have fallen much farther than can be justified by lower earnings. When we examine the relationship between stock prices and future corporate earnings, it appears that investors are pricing in a deep and prolonged recession. However, the forecasts of economists range between a mild and deep recession - but nothing out of the ordinary. The chart points to the impact of the recession on expected earnings, and how investors have overreacted to the same news. It shows the change in security analysts' earnings forecasts since the beginning of 2008 versus the change in stock prices. In it you can clearly see that the events of this year caused the analysts to reduce their forecasts of future earnings by about 15% for the 2008 fiscal year and 12% for 2009. At the same time, stock prices around the globe have fallen by about 40%. If the slowdown is in line with the economists' and security analysts' forecasts, global stock markets should recover much of the ground that they have lost this year as investors incorporate more realistic expectations into their investment decisions.

Overweight to stocks

Investors are caught up in a cycle of pessimism and excessive risk aversion due to recent events. However, we know from past experience that these cycles do not last forever, and once they turn, stock markets respond quite quickly. Stock prices have fallen much farther than earnings estimates, government policy is loosening the credit crunch, fiscal and monetary policy will keep the recession from being too deep or prolonged, and the cycle of deleveraging will run its course - these are all additional factors that support our bullish view. We don’t know when each of these factors will take hold, but we know that waiting for good economic news before shifting into stocks is not a successful strategy. Historically, stock markets have turned five to six months before the economic cycle. History has shown that times of great fear are the best time to buy stocks and the worst time to buy bonds.

Underweight the US dollar

The dollar has rallied recently due to a number of transitory factors, and these include a 'flight to quality', deleveraging and repatriation of assets by US based investors and corporations. However, once the current atmosphere of fear abates, and the cycles of deleveraging and repatriation end, the US dollar will fall to a level consistent with fundamentals. The negative factors include lower than average interest rates in the US and a large current account deficit for the foreseeable future. As with waiting for the economic cycle to turn, few can call these cycle bottoms, and waiting for evidence that they have turned is unlikely to be profitable.