FYI | Jun 07 2007
By Greg Peel
“Interest rates are rising and reaching critical levels. This matters more than growth for equities, so we think the mid-cycle rally is over. Our model is forecasting a 14% correction over the next six months, but it could be more serious.”
This was the warning last night from Morgan Stanley’s chief European equity strategist, Teun Draaisma. It followed as the strategists’ three key warning signals all flashed “full house” for the first time since the dotcom bust. This triple-signal has been triggered only five times since 1980.
From a Europe/UK perspective, the average fall in equities after such a signal has been 15.2%. A fall of 25.2% was experienced after the signal went off in September 1987, and a fall of 26.2% was experienced after April 2002.
However, Morgan Stanley is not warning of Armageddon. The strategists believe we are about to hit a necessary correction that, once played out, will signal a return to bull market conditions. The first indicator is equity PEs divided by bond yields. This captures the “froth” of the M&A boom. Equity PEs in Europe are currently running at an all time high of 20.
The other two indicators measure growth and inflation, and risk appetite. As many a strategist has warned, global liquidity has driven risk spreads down to unnerving levels. Something has to give. A trigger such as rate rises in Japan could be enough to upset the house of cards. But Draaimas suggests there could be “lots of little triggers”.
If a correction occurs, it follows that bond yields will ease once more. This is the automatic dampener on the system. Shake out the overextended risk positions, and it should then be back to business.
