An independent professional's take on the latest news and trends in global financial markets

Good news, bad news for equities

Why have I mentioned more than once the possibility of a strong stock market rally coming soon? There are several factors at work here. The normal end of year experience of markets finishing strongly is one of them. The oversold technical position in many markets, allied to very low trading volumes, negative headlines in the media and deeply bearish sentiment, is another. More fundamental though is the possibility – which I now rate quite high – that Germany will in due course sanction some kind of ECB involvement in the Eurozone crisis that will provide a trigger for all the investors currently sitting nervously on their hands to rush back into the market. It may not yet happen – the politics of the Eurozone remain fragile and complex, and nothing is certain – but if it does the effect in the short term could be very powerful.

The German policy of playing hardball with the rest of the Eurozone has already produced important changes in the political dynamics of the worst offending peripheral countries (Greece, Italy and Spain) and leaves the Germans in a strong position to dictate terms for any future survival plan. For pragmatic reasons, their hardline political rhetoric may soften if it looks like producing short term results they can live with. As soon as the markets get a whiff of that kind of outcome, the equity markets could take off very quickly, confounding the gloomiest doom-sayers in the process.

It is important to note however that saying a stock market rally is likely does not mean that either the stock markets or the world economy are yet out of the woods. A patched up Eurozone solution, if it comes, will not survive for long without a challenge, and most likely it will still fall apart at some point in the future. Equally there is no reason to be confident that the long-running derating of equities – which alongside monetary disorder has been the single most important theme of the 21st century to date – has yet fully run its course.

Long term valuation metrics, such as cyclically adjusted p-e ratios, suggest that equities are likely to produce positive ten-year returns from here, but that they won’t be as good as the long term average (6%-7% inflation-adjusted per annum).  Even if the Eurozone staggers on, in other words, the moment when that big cycle finally turns, which probably requires p-e ratios to fall to single digits, remains a way away. Some relief from the Eurozone trauma would still be welcome.

Written by Jonathan Davis

November 24, 2011 at 3:15 PM