Looking for the bright side

Are there any signs that this could be a buying opportunity?

WHEN Winston Churchill lost the 1945 election, his wife remarked that the defeat might be a blessing in disguise. “At the moment”, replied the great man, “it seems quite effectively disguised.”

It is possible, when investors view recent events in retrospect, they will see them as a turning point for markets. But if there are immediately bullish implications, they seem to be quite effectively disguised. The American authorities sacrificed Lehman Brothers “to encourage the others”, only to find the others were simply encouraged to deny funding to weak-looking institutions.

Risk aversion reached extremes this week as the money markets froze. Overnight dollar rates doubled in the interbank market while the rate paid by the American government for three-month money fell to its lowest in more than 50 years. In addition, the caning the authorities gave to shareholders in Fannie Mae, Freddie Mac and AIG, however hard to argue with, will make it tough for financial institutions to raise new equity. Wall Street did not even bother to rally after the AIG deal as it had after previous government interventions.

Bad news seems to be coming from all sides, leaving Hank Paulson, America’s treasury secretary, increasingly resembling a one-armed wallpaper hanger as he valiantly seeks to cope with the mess. Another problem emerged this week; a $65 billion money-market fund, Reserve Primary, suspended redemptions and warned that it would “break the buck”, ie, repay investors at less than face value. That could cause a flight out of other money-market funds. Meanwhile, credit spreads over risk-free rates have widened sharply and emerging markets have taken a hammering.

The “great deleveraging” is working its way through the markets, as institutions, unable to roll over their debts, are forced to sell assets. The resulting fall in prices raises doubts about the solvency of other businesses, giving the spiral another downward lurch.

So what good news can be found in the midst of all this gloom? The first, curiously enough, is that sentiment is very depressed. The latest poll of global fund managers by Merrill Lynch found that risk appetite is at its lowest level in over a decade. Such extremes are normally a bullish sign.

The second is that the government is not the only buyer. After Merrill Lynch’s sale to Bank of America, HBOS, a British mortgage lender, has also sought refuge within a bank, Lloyds TSB. That suggests executives see value in today’s prices. Whether this is out of shrewd bargain-hunting, state arm-twisting or over-ambitious empire-building remains to be seen.

The third is that the inflation threat has receded, thanks to the sharp fall in commodity prices. Eventually, that will allow central banks to cut interest rates. In addition, it will relieve the pressure on consumer demand and corporate profit margins.

The fourth factor is that central banks are also willing to undertake quite extraordinary market-support measures, including the Fed’s decision to accept equities as collateral against lending at its discount window. That would have been unthinkable 18 months ago.

The fifth issue is that valuations in equity markets have improved substantially. In Britain on September 17th, the yield on the FTSE All-Share index was higher than the yield on ten-year gilts. This has happened only once before since the late 1950s-in March 2003, which proved to be the start of a long rally.

However, it would be a brave investor that acted on those bullish signals today. Those who believed that the Bear Stearns collapse in March marked a turning point in the credit crunch were disappointed. The Vix, or volatility index, a measure of market preparedness for shocks, has been lower than in past peaks-though it shot up on September 17th.

While the money markets are frozen, other financial institutions may get into trouble. Buyers will be tempted to wait until asset prices fall further, a strategy that worked for Barclays, which was able to choose the slice of Lehman Brothers it desired. And the economy will surely have been harmed by this week’s turmoil; consumer sentiment will have been hit and banks will inevitably prove even more cautious about their lending. A recession seems more likely than it did at the start of the month.

Perhaps there will be no climactic sell-off to signal the end of the bear market. Instead share prices may simply bounce around in a choppy range near today’s values. It is quite plausible that those who buy shares today will look smart in five years’ time. It is much less certain they will look smart six months from now.