Leaving aside the Bernanke Bounce on September 18, emerging markets have fallen so far out of favour that it’s now de rigeur to label Goldman Sachs’ championing of the Brazil, Russia, India and China as nothing more than glib marketing. The conventional wisdom these days is that these four very different developing countries were only lumped together to form the snappy BRIC acronym.
That’s a bit harsh. Goldman, like other sell-side brokers, may be in the business of telling pretty stories, but that doesn’t mean its conceptual frameworks aren’t useful.
The latest pithy narrative to emerge from Goldman is about equity market cycles and, as with the BRIC concept, it’s presented with a nod to the headline writers. At the heart of Goldman’s The Long Good Buy is the idea that the world is on the cusp of two major market shifts, moving from Hope to Growth and from Fat and Flat (also known as The Lost Decade) to Strong and Skinny.
Hope to Growth is about the short-term cycle, where these two phases sit between Despair and Optimism in a sentiment roller coaster that every investor will recognise. Goldman’s key insights are that the phases of this cycle typically last for different lengths of time and are driven by different combinations of earnings growth and changes in valuation.
Despair spelt out
So, Despair is a roughly two-year period characterised by falling earnings and lower valuation multiples, a double whammy that sends share prices to absurdly low levels. The Hope phase follows when investors look through a period of flat profits to better times ahead. This period tends to be shorter and sharper, perhaps a year, although this time it was punctuated by the eurozone crisis and so extended for a couple more years. It is completely driven by higher valuations.
Hope then shifts into Growth, where the earnings improvements that investors had anticipated actually start to come through. These pick up the baton from valuations which, having risen sharply, then flat-line. This is where we are now, Goldman says, and the good news is that this period is typically the longest of the four. We’re set for around three years of more moderate but steady real price returns, if history at least rhymes.
Optimism revealed
Further out, Growth morphs into Optimism, when earnings start to roll over but animal spirits are high and valuations rise to silly levels. That’s a long way off but it’s worth waiting for because returns are second only to the Hope phase for those brave enough to hang in there.
The other transition, from Fat and Flat to Strong and Skinny, is a longer term, secular affair describing a shift from a volatile market of big ups and downs that ultimately go nowhere to a trending market with fewer violent swings when investors finally get paid for their patience. The good news is that Goldman believes cyclical Growth and secular Strong and Skinny are about to coincide.
The main drivers of Strong and Skinny this time will be recovering global growth prospects, low inflation, still-easy monetary policy and relatively attractive starting valuations. It’s a plausible case – helped by Ben Bernanke’s U-turn last week – that chimes with historical evidence that the big secular bear markets have tended to last for around 14 or 15 years (the last of these was broadly speaking from the mid-1960s to the early 1980s).
Supporting evidence for this coincidence of cycles is provided by the increasing perkiness of the new issues market in which companies on both sides of the Atlantic, from Twitter to Foxtons to the Royal Mail, are showing increasing willingness to risk a float. Less advanced, but very likely given the high levels of cash on FTSE 100 balance sheets and the proceeds of Vodafone’s Verizon sale, is a pick-up in mergers and acquisitions activity, which would reinforce the positive equity cycle.
Pucker up
The question then is how best to play the upturn and here Goldman’s final observation on strong and skinny markets is interesting. These kinds of stable trending markets tend to be associated with less risk-on/risk-off, macro-driven market movements. Returns instead are driven by company-specific factors. It’s a market of minimal correlations in which long-short hedge funds and stock pickers finally have their moment in the sun.
So, here’s to the KISS market – Keeping it Strong and Skinny.
Tom Stevenson is an investment director at Fidelity Worldwide Investment.
