An opportunity in the volatile stock markets

James Ferguson - Thu 15 Jun, 2006

...No one buying at these prices will regret it. The risk now of missed opportunity is greater than the risk of making further losses...

One of Warren Buffett's more famous aphorisms is along the lines of: "In our house we like burgers when they're cheap". Well, there's a positive fire sale going on in global stock markets right now and some of the deals look like the biggest bargains they've been for half a generation.

This is what successful investing is all about - taking advantage of temporary pricing aberrations. The question is: Are equities really as cheap as they look? Are markets being drastically oversold? I believe that they are.

There are all sorts of ways we can try and gauge whether we're facing short-term selling driven by traders or long-term selling driven by funds adjusting their positions (which is much more important). Unfortunately a lot of the figures come out with a short delay and with markets moving so much each session, even a short delay is too long.

The very speed of the moves and the universality of the sell-off scare people, bringing back memories of the dotcom crash and of 1987. But it is important to remember that these sharp moves are testament to the speculative nature of the beast in the short-term. If we put things in longer-term perspective, we see that markets are starting to look oversold, some very oversold indeed.

Let's take Tokyo. It's been the fastest running of the major markets recently and consequently the worst hit so far in these sell-offs. As a result, it's more oversold today than it has been for the last 14 years according to one measure, the 25-day To-raku.

The To-raku or gainer/loser ratio, measures the sum of the number of gainers over the past 25 days, divided by the losers. Since the Japanese bear market ended in March 2003 the average has been greater than one (more gainers each period than losers). However, today the ratio hit .54. That's not only the lowest for the last three years, but lower than any reading since August 1992.

Another measure suggesting Tokyo is oversold is the number of new 12-month highs versus new 12-month lows. There are 611 new lows in Japan and just one new high (and that's because it is subject to a management buy-out).

Market rebounds after such oversold conditions can be spectacular. Following August 1992's low for example, Japan's TOPIX index bounced 30% in just a month. I would be quite content with something much more modest this time.

Of course, these sorts of technical indicators are all very well. But with the FTSE having headed back towards May's lows after a couple of weeks of strength, we need to know whether we should be buying stocks down here. Can they be expected to enjoy more than a trading rally? The answer to both questions is "Definitely".

Stock indices have tumbled as much as 15%, equities are not just the cheapest choice relative to all the assets available. By historical standards, they're outright cheap too.

US stocks are today on a lower prospective p/e than they have been for a decade. If that doesn't whet your appetite, how about French stocks? They haven't had such a low p/e as they have right now for 14 years. And then there's the FTSE 100, that fine bastion of investment value: it now trades on its lowest p/e for 15 years - half a generation!

Encouraging stuff, but that's not the truly amazing bit. Fifteen years ago, when the FTSE100 was last on less than 12 times forecast earnings, the year was early 1991 and Gilts yielded over 10%. Stocks needed to be so cheap to compete with the great rates available from bonds. Today bonds are less than half as attractive as they were back then (they yield about 4.6%) so it just doesn't make any sense for equities to be the same price today as they were back then.

To cite Warren Buffett again, he always talks about a hypothetical Mr Market who comes to you each day with a different price. What you have to do is decide if his price makes you want to buy or sell. This is quite different from the Efficient Market Hypothesis that the academics use.

Efficient markets mean that we assume that the price has information in it. If the market has just dropped, there has to be a reason because the market is efficient and only responds to news. But we don't use such an assumption so blindly in our daily lives. If we see a sudden price drop, we tend to think it's a bargain. We don't get less tempted and more suspicious the lower the price goes.

But in financial markets, people sometimes do. A falling price can make them think a stock is actually less attractive. That can create huge volatility because a rising price can also make people think it's more attractive again. This is why Buffett wrote in one of his annual reports during a vicious bear market, when all his peers were getting more and more negative: "Charlie [Munger, his long-time business partner] and I see prices going down and we feel like kids in a candy store."

So everyone is waiting on everyone else. They'll all wait for someone, somewhere, to start the buying. When it does happen the turnaround could be very swift, so the sensible approach is to go in a little bit early, whilst it's still falling, and wait for the rebound. And some simple technical analysis says that time is most probably now.

Indices are rebounding strongly. The US S&P Composite index is already 2% above yesterday's low, Tokyo's TOPIX index closed 2.3% above its intra-day low and these sorts of moves have inspired a similar jump in London. There may well yet be further volatility to come but the FTSE bounced from a higher level than its low of a fortnight ago. That means that for now at least, there's a new trend of rising lows - an upward trend in other words. That's a bullish sign.

Make no mistake, this is one of those times when it is right to raid the building society funds and have more of a dabble in the markets than normal. Can I guarantee that we've already seen the lowest prices for stock markets this year? No I can't. But I can say that no one buying at these prices will regret it. The risk now of missed opportunity is greater than the risk of making further losses.


Regards,

James Ferguson
for The Daily Reckoning