A Bull Market Correction
Having accurately predicted a correction in the UK stock market we feel frustrated that we did not lock in the gains from the early part of the year. The truth is we did not anticipate such a severe and wide reaching correction.
We became nervous of the advancing stock market when we saw what a narrow range of stocks was driving it up. We believed there would be a short and sweet correction resulting from a switch in sector allocation away from the resources and into other parts of the market. We were not so lucky. The speed and duration of the fall in May was one of the worst the UK has experienced in the last thirty years. We have seen our historically lowly rated investments, all of which have attractive and growing free cash flows, fall alongside the over owned and expensive resource and industrial stocks.
Please don't get bored listening to a stuck record. We do believe we will be proved right but should have realised from past experience that stock market fashions always take longer to unwind than one expects.
We also know from past experience that the stock market is a clever animal. As soon as it senses over confidence among investors it sends a shock wave: the lesson is that money does not grow on trees. The recent bull market correction has frightened many investors away and has prompted fears that we are entering a bear market. This is not the case. If it were, we would be seeing wide spread downgrades in earnings estimates or significant changes in economic indicators such as a fall in GDP growth. It is a bull market correction because the fall did not occur due to fundamental changes but was in fact a reaction to speculative investing.
The threat of the withdrawal of nearly US$200bn of virtually free money by the Bank of Japan was no doubt a contributory factor to the worldwide falls in stock markets. A lot of this money was used in speculative trades creating a false market in commodities and emerging market stocks. As soon as the tap was turned off, the trades were closed causing these markets to suffer severe corrections. The Japanese Government could not have foreseen the significance of their move to restrict the flow of money.
Rather than wallowing in self-pity, we should take satisfaction from the realisation that this is merely a bull market correction and focus on the attractions of our core holdings. Our favoured sectors, the financial, media, pharmaceutical and telecom sectors, look even better value than they did before the correction. Valuations are close to trough levels and significantly below historical averages and they all exhibit attractive increases in free cash flow forcing us to revise our cash flow estimates upwards on a regular basis. Numerous pieces of research highlight that banks and pharmaceuticals are cheap and over owned and that technology, media, telecoms and retail are cheap and under owned yet all these sectors remain out of vogue.
We also remain sure of the potential for our investments in unit trusts and investment trusts in the emerging markets. The risk of investing in these countries is countered by the potential for significant further growth as the economies develop. We are comforted by the fact that many of the emerging economies have undergone structural changes leading to more manageable levels of debt, enabling them to control inflation and, in many cases, run current account surpluses. Governments are being more restrained in the financing of companies thereby preventing companies from flooding the markets with products and upsetting pricing and the balance of supply and demand. Companies are instead trying to attract funding from the global financial markets. In order to achieve their goal they have been forced to monitor their financial activities more closely. The result is that they have become more westernised in their approach and have become increasingly restrained in their activities because they are having to answer to vocal western shareholders.
In the medium to long term we are confident that we will see positive market returns and therefore believe the recent correction provides a good opportunity to increase exposure to the equity market. In the short term we are concerned by the continued strength of the resources and fear that if and when expectations are revised down the market will suffer another correction.
30 June 2006
