Making sense of the August stock market debacle

The August market downturn gave the world a big scare and investors seemed to have run for the hills in fear the nightmare from 2008 was returning. Ron Bewley tries to make sense of last month’s debacle and finds it is hardly the end of the world.

February and August are always special months for stock market watchers. They are the months in which companies report earnings and paint pictures for the future. There was much speculation in the media before this last August that companies would be forced to ‘confess’ before the season opened.

The media called for companies to downgrade their earnings estimates in July before they reported. That didn’t really happen and about a third of companies beat market expectations, a third missed and the rest just did what we all expected. Not bad at all. Certainly, it didn’t make the professional doomsayers happy. 

But anyone who was on planet earth during August would be aware that most things that could go wrong seemed to go pear shaped. US debt was downgraded for the first time ever, the US Congress squabbled on the debt ceiling and the way forward, European leaders got in a pickle over their debt crises, the US east coast was battered by a hurricane and a 5.9 earthquake to boot. It should be no surprise, therefore, that markets tumbled.

The German DAX fell by nearly 20 per cent in August, the S&P 500 fell sharply but recovered to be about 5 per cent down, but our market fell by less than 3 per cent after its recovery. The problem I want to discuss in this note is how big really is the problem – using facts, not just emotion.

It is important to appreciate that Standard & Poors’ (S&P) give two ratings – one for the short-term and one for the long. It didn’t get much attention in the media at the time, but S&P actually reaffirmed its top notch rating for the US short-term debt – the important one – and only downgraded the long-term rating.

That means S&P sees no problems for a year or so – plenty of time for Congress to do something about it. S&P also didn’t question the US ability to control its long-term future – the downgrade was specifically given for the inability of the Congress to come to a decision before the eleventh hour – a bit like a yellow card in soccer.

That can be fixed too – without being sent to the sin bin. Of course, it is all really embarrassing for President Obama and anyone involved in running (or is it not running) the country.

There are three major ratings agencies, and, like with the three tenors, most can’t remember the name of the third one – Fitch Ratings. Fitch publishes probabilities of default (PD) each day for companies in certain regions of the world. Share prices and credit default swaps (CDS), that is the price of insuring debt against default, are both subject to fundamentals and emotion.

I think the way Fitch, and others, calculate the PD is a far more robust way of reading the extent of the real problems in the world. Fitch produces estimates of a credit event or default occurring with a one-year period and for a five-year period for North America, Western Europe, Asia Pacific and Emerging Markets – as well as for the world – for the ‘average company’.

Chart 1 shows the one-year estimates for two of the regions.

The data is only available from March 2001 during the aftermath of the tech wreck and the Asian crisis. Of course the 9/11 terrorist attack occurred at the beginning of this data period. By 2004, the one-year PDs had settled down and stayed that way until well into 2008: the global financial crisis (GFC).

Until the end of 2009, there wasn’t much difference between the PD estimates for North America and Western Europe. In 2010 and beyond, the North American estimates returned to historic lows with a tiny flick up in August 2011. In my opinion – not the stuff of a crisis. No repeat of the GFC is even slightly evident in this data.

Western Europe is a different kettle of fish. While the PD estimates for Europe are low, there is now a wedge between the two regions’ estimates. To me – this is how I read the situation from watching international TV. As with S&P and the US debt, there is no imminent problem apparent from these data. But if we now move to the five-year estimates in Chart 2, a different picture emerges.

There is naturally a much bigger chance of a company defaulting over a five-year than a one-year period, and the scales of Charts 1 and 2 reflect this. Apart from scale, the run-up to the GFC was similar for these two regions and the two time horizons for possible default – until the GFC was well under way.

However, Europe became more problematic in 2009 and beyond as the crises in Greece, Ireland, Portugal, and to some extent Italy and Spain unfolded. I am not surprised by this comparison given my market watching. But my main reason for introducing these PD comparisons starts in August 2011. The five-year PD kicks up strongly for Europe and noticeably for North America.

The PD for North America should not alarm – the current level (7 September 2011) is around the range experienced for 2004–2007. The kick is coming from a low base. However, the five-year PD for Western Europe didn’t even get down to the pre-GFC levels and the PD doubled during the month of August to a level that is well within the range experienced in the early part of the GFC.

But it is important to put two things into perspective. The European one-year PDs are fine but the five-year are not – so the problem is not imminent.

Importantly, PD should be read as ‘the probability of default within a given period if the company takes no evasive action’. This definition is roughly the one I used with the Financial Strength Indicator I used to publish at the CBA for the PD of ASX 200 companies. The problems at company level have time to be fixed but, left unattended, credit events will follow further down the track.

Contagion – or a domino effect – is the new word for some after the GFC. Of course, it was contagion that escalated the Asian currency crisis, and the South American credit crisis that followed the Mexican crisis.

Some people are currently claiming that credit events in Europe will sweep the world – if they start – through contagion. The investors’ behaviour contained in the PD estimates for 2011 is drawn from much the same group of investors who experienced the GFC and the Asian crisis in Charts 1 and 2.

If they thought there was likely a contagion effect in the five-year PDs from Western Europe to North America, the data in Chart 2 would show that – and it doesn’t. In my opinion, Europe is in for a long hard slog, but North America can largely avoid any contagion. If North America and China are fine, Australia is in reasonably good shape.

From time-to-time I publish my forecasts for the sectors of the ASX 200 and the whole market in this magazine and elsewhere. I always find it interesting to monitor these forecasts during reporting seasons to see how the new information is being digested.

This time around, there were some big changes. The reported earnings came in fine but companies’ outlook statements were guarded – why wouldn’t they be!

At the time the outlook statements were being made, market volatility was almost as high as during the GFC and I think only a fool would have ignored this uncertainty in an outlook statement – even if the company did have a reasonable view of the future. I show my forecasts of capital gains for the next twelve months from both the end of July and the end of August 2011 in Chart 3.

There is no doubt that the forecasts have come off – by about 4 per cent for the ASX 200. However, the average historical market return is about 7 per cent over any reasonable time period so the implied forecasts from broker estimates of 10 per cent is for a better-than-average next 12 months – just not as bright a future as they saw a month before. 

The sector forecasts tell a really interesting story. The utilities’ and industrials’ forecast has been slashed and the new Consumer Discretionary forecast – including companies like David Jones and Harvey Norman – is weak.

These changes in the sectoral forecasts are evidence of the recognition of the two-speed economy. But any portfolio with an emphasis on resources and financials – particularly when dividends are added into the mix – looks solid, based on these broker estimates and my interpretation of them.

When the dust settles on all of the world issues and the US downgrade becomes a distant memory, what will happen to these uncertain outlooks?

To me – putting all these analyses together – there is some reasonable chance that the broker forecasts will be upgraded back to where they were at the end of July.

In the few days since the end of August, Italy has passed its new austerity bill, a German court has found that they can help bail out other countries, the US got a great read on both retail sales and the services sector – and we got a soft but OK employment read. Not the makings of the end of the world to me.

Dr Ron Bewley is the investment consultant at Infocus Money Management.