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On the defensive

Warren Buffett says: “Be fearful when others are greedy and be greedy when others are fearful”. In October, he put this into practice, buying US equities for his personal account and predicting that “the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up”. There are several reasons why now might be a good time to revisit the equity market.

Falls as extreme as those in October are few and far between. Only four periods over the past 100 years match the 46 per cent fall since the S&P 500 index reached its high in October 2007. The S&P 500 subsequently regained as much as 20 per cent but then retreated again and continued to trade in a volatile range throughout early November. Most other equity markets have displayed similar patterns before lapsing into a range.

The theory of mean reversion suggests that prices and returns ultimately revert towards the historical average. During October, many defensively positioned core funds in Western markets outperformed their indices by three standard deviations while many funds in perceived “high risk” stocks fell four standard deviations on a 12-month view. Such deviations can, of course, persist for months but these exceptional levels suggest that gradual additions to selected equity holdings could be beneficial and, while the market is likely to remain volatile, there are signs that it may be near a bottom.

At the heart of the recent turmoil has been banks’ unwillingness to lend to one another. A return to confidence is a necessary precursor of a market recovery. A good indicator is the Ted spread, which is calculated using the difference between the interest rate on three-month US treasury bills (T-bills) and three-month dollar-denominated Libor. This shows perceived credit risk in the economy as T-bills are deemed risk-free while Libor reflects the credit risk of lending to commercial banks. An increase in the Ted spread suggests that lenders believe the default risk on inter-bank loans is rising because it shows lenders are demanding a higher rate of interest from counterparties or are accepting lower returns on “safe” investments such as T-bills. Having spiked to exceptional levels in October, the spread had returned in early November to normal levels of about two percentage points.

While the worst may be over, a sustained bull market looks still some way off. Credit conditions must return to normal and earnings and returns on equity have further to fall before a recovery can begin. In the meantime, investors should focus on more defensive areas with earnings’ sustainability.

Mark Harris is head of New Star funds of funds team

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