History repeating as equities lead the charge

A colleague of mine pulled up a chart recently on the US stock market.

It showed that equities rallied strongly before the crisis was actually over. No, we’re not talking about 2012, but 1943. From 1943 onwards, US equities recovered sharply and continued that trend through the end of the war in 1945.

I’m sure if you asked an average citizen in 1943 how they felt, you would have found that the mood was still sour. D-Day had yet to happen and uncertainty prevailed about who was winning and losing. Yet the stock market detected fundamental shifts that favoured the Allies.

Now think about the present day. It sure feels difficult to be a citizen of Europe, particularly in countries such as Ireland. Unemployment is elevated, economic activity is muted and it is often easier to interpret events negatively.

Yet stock markets have rallied by over 23% since last October. The bears will tell you it’s a false dawn and that wretched levels of debt and government retrenchment will kill any buoyancy on the economy. However, the markets motor higher.

Part of this is due to a more dynamic leadership in the European Central Bank. Since taking his post, Mario Draghi, the new head of the ECB, has lowered interest rates and provided the banking system with billions of inexpensive euro.

This helps lower the cost of money and frees up the money pipes that plumb the European banking system. That, in turn, has helped the banks trade assets more actively and, in doing so, improves their profitability.

We may not like to hear this, but a more profitable banking sector helps heal the dire lack of capital in the system and reignites interest in lending to the wider economy. Mr Draghi’s moves have rekindled equity investor interest in banks and they have led a so-called “risk-on” rally. That means equity buyers are picking up companies that would be at the vanguard of a broad recovery, including airlines, paper packaging companies and construction stocks.

Aside from the monetary stuff, it is clear that the enormous US economy is doing better than the naysayers thought. Germany continues to power on, while Japan is recovering from the 2011 tsunami. These economies could post positive year-on-year data in 2012 that supports a rising stock market.

Another factor not to be ignored is the opportunity cost being paid by those invested in safe haven assets. Bonds in the US and Germany have billions invested in them, yet they pay a minuscule yield. Once investors in those assets sniff stability in the euro, there could be a wall of money hunting down equities with growth prospects and dividend yields much greater than those attainable from treasuries and bunds.

The stock market does not think in terms of weeks or months. When you buy shares on a price-earnings ratio of, say, 10x, you are paying 10 times this year’s profits. If those earnings are depressed due to the recession and the euro crisis, but pay good dividends and are backed by strong balance sheets, then they could be a bargain if in years two and onwards (ie 2014) profits normalise along with the economy. This happened in 1943 and we could now be seeing the same dynamic.

I remember in the early noughties being laughed at when arguing that equities were the most dangerous asset class on the planet. They still are, and anyone thinking of purchasing equities must also start with the premise that they can afford to lose all of their money.

With that mindset, it is somewhat easier to contemplate buying an asset class that performs better than all others over the long-term. Equities are signalling something and it would unwise to ignore them.

Joe Gill is director of research with Bloxham Stockbrokers