Money Talk: Time to hold your nerve
QUESTION: I have heard differing comments as to where the stock market goes from here. Some people talk about the fundamentals being good for investing, citing all forms of ratios to back up their argument. What do they mean?
ANSWER: Global equity markets peaked on or around July 19 this year but since then markets have declined virtually everywhere and we have seen a correction of 13% at the lowest point.
The catalyst for these corrections has been the shake-out in the American sub-prime mortgage market which has resulted in some banks and investors suffering significant losses in relation to sophisticated structures based on this segment of the market.
All of this means that there is currently a huge demand for cash as banks and institutions aim to maintain their liquidity and other finance arrangements.
The best place to source cash is selling equities, which can be easily liquidated and have good profits after almost four and a half years of a strong, bull market.
In my view the underlying price cannot truly reflect the valuation of the shares and it is more a case of forced selling in order to raise cash at whatever price you can get.
The current market volatility is therefore, in my opinion, a correction in the prices and not the beginning of a bear market, ie a prolonged period in which investment prices fall.
One key measure when looking at prices in the stock market is a factor known as the price-to-earnings ratio (P/E ratio) or a share's earnings multiple.
In short, it is a reflection on the price a share stands at relative to the income or profit earned by the share. The higher the P/E ratio, the higher an investor will be paying for each unit of income.
Previous market crashes that have led to bear markets - such as those seen in 1987 and 2000 - have happened at a time when shares have become expensive relative to their historic prices and companies begin to trade at around 20 times earnings.
This is not the environment that we are currently in.
The FT All-Share Index is currently trading on a P/E of 13, brought about largely by cheap mega cap stocks, which is below the historic average of 16 and still therefore some way off the highs that we have witnessed in the last 20 years.
That is why many commentators are observing that they still feel that stocks are reasonably cheap.
That isn't to say that in the short term we won't continue to see some volatility.
Markets around the world still feel they have to be fully informed as to how the US sub-prime problems will affect the major financial institutions.
In addition there are other, less objective factors that will have a bearing on how the markets perform.
Market sentiment and the other emotional factors that affect prices will come into play.
We cannot simply rely on logical objective analysis to dictate prices over the short term.
However, when you take the emotive response away from investing and concentrate on the fundamentals that drive markets, such as stock valuations and economic factors, equities continue to remain an attractive asset class for investment and right now there is a sale going on.
Nonetheless, and as I have commented on many occasions in this column, the secret to long term investing is to have a balanced portfolio that contains each of the asset classes, namely cash, property, debt (be it government or corporate) as well as equities.
So for those of you who are prepared to accept the short term volatility in anticipation of long term gains, now may be the time to discuss with your adviser as to how best you could pick up some of those end of sale bargains in equities.
Raymond Mulligan is managing director of Johnston Campbell, a company of independent financial advisers regulated by the Financial Services Authority.