I remain very pessimistic about the equity markets and the target of 2500 for the CAC 40 in 2011 remains valid to me. The drivers of the recent rise, both in the U.S. and Europe, are not healthy (this said, good for those who were able to capture the move). These bullish factors are not sustainable. Let’s do a review, here are four:
1- The U.S. economic policy is a suicide
In monetary field, we have the U.S quantitative easing and abundance of liquidity; the aggressiveness of this economic policy is with no comparison with an expansionary budgetary policy, not to mention foreign exchange when the monetary authorities, with benevolent complacency of the political authorities, can manipulate the change, as it was the case between August 10, 2010 and November 02, 2010. In other words, this economic policy leads the international financial and economic system straight into the wall.
Most economists do not seem to express concerns on such an imbalanced and uncooperative economic policy, mostly inefficient for growth on the long run. We bet that everyone will write in some quarters that the U.S. monetary authorities and politicians were unconscious. We prefer to do it right now and draw the consequences in terms of market bets (bear stock markets, rise of inflation expectations, bearish on U.S dollar against all currencies except Euro)
2- A craze for equities due to the attractiveness of dividends
Sorry but equity is not bond and if you buy an equity share only for its return then it is, in a way, the end of "Equity culture". And besides, a company that distributes too generous dividends is a company without viable projects on neither organic nor external growth: it is a company more concerned about showing ratios of return on capital rather than a true sustainable development policy.
3- A revival of special situations and cross-border mergers and acquisitions in many sectors
This interest is also due to the fact that the world is excited about the revival of special situations and cross-border mergers and acquisitions in many sectors. Even if some IPO targets exhibit good potential valuations (and we should not deny it), it is not sufficient to generate a structural bullish trend on stock market indices.
4- Stocks are assumed to have attractive valuations
I hear and read all day that stocks have attractive valuations (the kind of simplistic shortcut that makes me jump) because long-term rates used to discount future benefits are historically low. Fortunately, naivety and gullibility do not kill...What do they mean by long-term rates and what is a good proxy for a long-term rate to value a share of the Euro zone in 2010?
Should we refer to the 10-year Bund (which is not even a risk-free rate and has never been), Euro zone’s average government bond rates, CMS 10-year, 10-year rate of a BBB corporate, 10-year rate of senior bank debt or subordinated one? .. Better yet, shall we use long spot rates (observed on the spot markets) or forward rates or even forward rates with a risk premium associated with risk aversion ... We see therefore that the attractiveness of stock valuations is not so trivial and obvious..
In any case, these are four so-called good reasons to buy equities in 2011. I do remain convinced these are misleading and unfortunately strong structural elements of stocks underweighting, in 2011 and beyond, remain very present. We have been presenting these factors for recent months: changes in regulations forcing many investors to underweight equities; very important upcoming recapitalization needs in banking & insurance sector through capital increases; risks of systemic crisis linked to some banks, insurance companies and countries in the euro zone (despite the IMF, ECB, The European Union and its European Financial Stability Fund); renewed long-term inflation expectations amid bond market crash.
Anyway good luck to those who have decided to overweight equities for the four false reasons mentioned above. All this should not prevent investor from stock picking and monitoring opportunities in real growth stocks: firms able to enforce sale prices (the well known "pricing power"); companies taking advantage of the increase in some raw materials; companies with high exposure to the growth of some emerging areas, regardless of the country they headquartered in.
But in no case should the monitoring of such opportunities lead to overweight equity asset class. We shall address more specifically this point in a paper on what should be an optimal asset allocation for years to come.
