Happy 5th Birthday, Dear Financial Crisis

In part one, I explained the sequence of events that was the global financial crisis. It started in February 2007, with the first reported mortgage losses. But it wasn’t until March 2009 that stock markets plunged to their crisis lows. Today I’ll explain what happened next, and what investors should do today.

It’s easy to forget that the crisis was on a long fuse and not a short one. From the start of the crisis to the stock market bottom was  a period of just over two years. If we say the epicentre of the meltdown was the stock market bottom, on 9 March 2009, then we can say “Happy 5th Birthday, Dear Financial Crisis”. But in fact it’s just over seven years since the waters originally broke at HSBC, in February 2007.

Interestingly, and perhaps worryingly, the banks are still in recovery mode. Many are shrinking their balance sheets as they continue to work off bad assets, and struggle to meet new and much tighter regulatory capital requirements.

But never fear! The banks still have vast and expanding gross derivative exposures that could blow the whole house of cards down again. The difference today is that developed country governments are now drowning in debt.

…our glorious leaders may not be able to borrow to bail out the banking industry a second time. And they can’t slash interest rates either, as these are already on the floor.

In other words, our glorious leaders may not be able to borrow to bail out the banking industry a second time. And they can’t slash interest rates either, as these are already on the floor. Printing vast amounts of money could be all that’s left if another crisis comes along (see here and here).

This is one of the essential reasons that I recommend that every private investor owns physical gold coins or allocated gold bullion (your direct property). It’s disaster insurance in a risky world.

But in the longer term ever growing physical gold demand in large and growing countries such as China and India, combined with relatively tight supply, should keep driving the gold price higher.

Back to stock markets. What’s happened since the crash?

Take a look at this chart which compares an ETF that tracks the MSCI Emerging Markets index (in blue) with the US S&P 500 index (in red). Both are measured in US dollars, and the period is from 9 March 2009 to today.

MSCI vs US S&P500 Index

MSCI Emerging Markets index US S&P 500 index

RED: US S&P 500 index
BLUE: MSCI Emerging Markets index

You can see that the emerging market index raced ahead of the US index at first. By April 2011 it was up 115% against 80% in the US. Then the emerging markets fell, not least because some of them were trading at extremely high P/E ratios in April 2011. As a group they have moved sideways since late 2011. Some country P/Es have remained elevated, but some have come down significantly.

Take another look at the chart and you’ll see that it wasn’t until the start of 2013 that the US stock market broke away. Last year the S&P 500 rose 30%, whereas the MSCI Emerging Markets index fell 5%. That trend has continued into 2014 as investors have become concerned with the situation in several countries such as Argentina, Turkey, Thailand and most recently the Ukraine (where panic over what might happen has hit Russian prices).

But S&P 500 earnings-per-share (EPS) grew by less than 5% in 2013, according to data from Factset. Even weaker was sales growth. Sales-per-share were up just 1.8%.

In other words, US companies had better see some serious sales and profit growth this year if the current S&P 500 P/E of 17.8 is to be justified.

I think that is unlikely. Investors in US stocks will most likely see relatively poor returns in coming years, and may even see sharp price falls (which would be a buying opportunity). Earnings need to grow just to justify current price levels. Continued weak earnings growth could mean prices fall.

…the US market has powered ahead so strongly, in the absence of strong revenue or earnings growth, it looks to be running a little hot.

Precisely because the US market has powered ahead so strongly, in the absence of strong revenue or earnings growth, it looks to be running a little hot.

And precisely because emerging market stocks have been weak performers since April 2011 they now offer good value. Taken as a whole, the MSCI Emerging Markets index has an undemanding P/E around 10.

In fact certain markets, most especially Russia, are extremely cheap and therefore extremely attractive. The Russian market P/E is currently around 5, with a nearly 4% dividend yield.

But while we wait for emerging market share prices to head higher, let’s raise a glass, fellow OfWealthers, to say “Happy Birthday” to the global financial crisis.

A great many people lost a lot of money during it. But a lot of money has been made since, by those that bought near the stock market bottom.

Indeed it was the worst of times for most. But it was also the best of times for many. We’d do well to remember that and act accordingly the next time a crisis comes around. But for now at least, the best stock market bargains are to be found in the emerging markets.

Stay tuned OfWealthers,

Marco Polo

marcopolo@ofwealth.com