The Inefficient Market: Beware the rocks (breakingviews)

The aftermaths of speculative manias are always trying times for investors. To produce profits they must sail against the current of a falling market. In addition, they are faced with nasty surprises, as the particular excesses of the bubble come to light. As Walter Bagehot, the great nineteenth century editor of the Economist, once noted: 'the rocks only show once the tide has gone out.' How can investors steer themselves round the rocks and come safely into harbour?

We start with a premise that is not universally accepted. The US corporate sector remains bloated after the fat years of the bull market. Non-financial corporate debt in the United States at the mid-year was over 181% of GDP. Current capacity utilisation in the US is around 75%. This year corporate investment has been reasonably strong, as many firms anticipated a short economic slowdown. However, given worsening economic news, it is likely that a sharp fall in corporate investment is round the corner. Given a combination of high corporate indebtedness, falling profits and large excess capacity low interest rates are unlikely to boost corporate investment in the near future.

Nor can we expect the American consumer to bail out the private sector. US households are also heavily indebted. As the stock market has fallen, their balance sheets have worsened. Unemployment has also been rising rapidly. So far this year these problems have been concealed by falling interest rates and associated mortgage refinancing. This cannot go on forever. Despite federal tax rebates, the US consumer is not in the position to sustain growth. In short, the United States is facing a liquidity trap in which further drops in interest rates may do little in the short run to revive the economy. In fact, with inflation falling and the spreads on corporate bonds rising, real interest rates may actually rise in the near future.

What should investors do when faced with a liquidity trap? The best advice is to get out of the stock market altogether, and shift funds into cash and risk-free government bonds. However, those investors brought up on the notion that market-timing is a cardinal sin and those who fear that missing the start of a bull market is a sackable offence will be reluctant to follow this advice. Long-only equity fund managers are forced to stay in the market, whether they like it or not.

Equity investors need not despair, however. There are ways to limit losses. They should start by looking for stocks with large and secure dividends yields. According to a recent report from the quantitative strategists at Dresdner Kleinwort Wasserstein, a portfolio of high yielding stocks has greatly outperformed the US and European markets over the past 18 months. Investors should also look to firms with pricing power. Such companies are likely to have strong market positions and low volatility in their top line. Non-cyclical sectors - such as pharmaceutical, food producers, beverages, defence, and utilities - should also do relatively well in deflationary times.

What should investors avoid? First, they should steer clear of sectors - such as semi-conductors and telecommunications equipment suppliers - which received too much investment during the bubble years and are now faced with overcapacity. Secondly, investors should avoid sectors which are highly exposed to international trade since weak prices for traded goods is one of the prime sources of deflation in the modern world. Sectors such as steel, capital goods, and automobiles are particularly at risk from global deflation.

Most importantly investors should avoid highly indebted companies. During a deflationary period, the value of debt rises as interest rates fall. Everything else being equal, the bondholders' profits will be offset by the losses of shareholders. Furthermore, over-leveraged companies may face problems with refinancing and see their credit ratings fall, which means that both shareholders and bondholders lose out (although the latter will face relatively smaller losses).

Unfortunately, much corporate debt is held off-balance sheet, which makes it particularly difficult for investors to spot. For instance, Enron, the troubled US energy crisis, seems to have used related party transactions to keep debts away from the scrutiny of shareholders and creditors. This appears to be a classic case of what J.K. Galbraith called the 'bezzle' - the fraudulent and illusory increase in wealth - that occurs during financial bubbles.

Finally, investors should shun any businesses whose profitability is closely tied to the level of the stock market. The list is long, it includes: life insurance companies, firms with large defined-benefit pension funds, companies where profits have been inflated by stock option compensation and most financial services businesses. Investment banks, in particular, should be avoided like the plague. In the past, the collapse of every great financial bubble has been accompanied by spectacular financial failures, like that of Yamaichi Securities in 1997. This time is unlikely to be different.

Author: Edward Chancellor