Stock Market Update – September 2011


We have all seen the continual stream of negative news, particularly in the last six weeks, about a European debt crisis, US debt crisis, China slowdown risk and sharemarket falls.

The question remains, should we be selling, watching or buying?

We see all three could apply, with the answer depending as much on the person asking the question as on what is going on in financial markets around the world.

A key difficulty is the overwhelming sense of uncertainty

In reality, uncertainty is always with us, but it seems worse at the moment. That is because the risk is more obvious than normal, specifically “will there be one or more defaults by countries, probably European, on their debt?

We are well aware that multiple debt defaults could have a serious impact on the world’s banking system, especially on banks in Europe. However, we also note that there have been sovereign debt defaults before and they were absorbed, but not without some pain. The better known recent ones are Russia in 1998 and Argentina in 2001.

Iceland’s currency fell substantially in 2008, leading to an equivalent effect of partial debt default. But in each case, after the initial pain, financial markets and governments adjust and keep back to more normal operating conditions.

In 2008, the American credit market crisis was made far worse than most market participants expected because of derivatives.

Few knew of the scale of derivative exposures and so few could protect themselves. A principal difference today is that the sovereign debt risks seem well know: debts levels in each country are known and who owns that debt is known.

So it doesn’t seem there are the same “hidden risks” as in 2008. But why aren’t things being fixed then?

The answer seems to be “political will”.

The recent Jackson Hole speech by US Federal Reserve governor Ben Benanke had a relatively simple underlying message: “We central bankers have done our bit, now it’s up to you politicians to make some sensible decisions”.

We all hope that politicians aren’t so bloody minded that they are prepared to bring the system down to make a political point.

But even in Australia, we see childlike political point scoring winning out over reasoned debate, so the risk is there.

And while debt default is a big news item, economic data has seen a gradual lessening in growth rates around the world.

The recent drop in the IMF’s predicted the average global growth rate for 2011 from 4.3% to 4.0% doesn’t seem much but is enough to make a difference, given that average developed country growth is forecast to be 1.6%. For Australia, 2011 growth is forecasts to be 1.8% versus 3.0% in 2010. For 2012, forecast growth has been reduced from 3.5% to 3.3%. This is still well in excess of 2011 and higher than 2010. As part of those changes, the IMF noted that confidence has fallen sharply and downside risks are growing.

From a share market perspective, investors are obviously nervous

The market is back to levels of July 2009, despite two years of healthy profitability since then. Company balance sheets are strong but business conditions have weakened for some in recent times.

Bank deposits look attractive with interest rates for depositors in the vicinity of 6%. But major stocks look even better.

When franking credits are included (which they must be if doing a valid comparison with other income yields), our major bank shares have income yields of 10% to 11%. Telstra is 13%, QBE 15% and Woolworths and Wesfarmers 7%. While companies can always reduce their dividends, major companies typically try to avoid doing that.

If you can see shares for the longer term investment they should always be, current dividend yields are at levels that don’t require any future capital growth to produce an adequate investment return, provided dividends don’t have sustained falls.

While we can see some risks to company profits, on value grounds we consider many shares are at attractive levels for long term buyers. In general, risk is highest in share markets when valuations are high and dividend yields low. Risk is lowest when valuations low and dividend yields high, as is currently the case.

That therefore suggests that longer term investors shouldn’t sell, unless there is good reason to expect further substantial price falls. And that comes back to political will and global debt markets. Short term deadlines in debt markets are over-shadowing the longer term picture.

If you are happy to look through that we see no reason for across the board selling. Even if there are further falls.

However, if you are unable to accept any further price declines, then consider a sale. Note that the risk then becomes not being in the market when prices recover.

If you wish to add to existing holdings, we recommend waiting.

That is based on there as yet being no technical indicators that a sustainable rise in share markets has commenced. While that will no doubt mean missing out on the early part of any recovery, we consider that more prudent.

Of course, you should take any decision about what to do with particular investments in the context of your overall portfolio. If your share holding is modest anyway, there is less reason to feel short term concern. If shares are a substantial proportion of your portfolio, then there is more reason to review. Are all your holdings appropriate?

– David McKenzie (Senior Financial Adviser)

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Disclaimer: Information contained within this article is of a general nature. Do not be rely upon it when making financial decisions. Please consult a professional financial advisor or planner (like us!) before acting.