Stock Take

Stocks correlations:We noted recently that correlation in US stocks is at truly dysfunctional levels. In Europe, Goldman Sachs noted this week, correlation between European shares and bond yields is at a 40-year extreme.

“The way European equities have performed recently suggests investors are more fearful about growth – and less worried about inflation – than at any time in the last 40 years,” Goldman said. Rising bond yields are invariably seen now as good for equities, with falling yields implying declining growth or even deflation.

Worryingly, high correlation has also prevailed in Japan in the last 15 years. In that time, Goldman said, Japanese bond/equity correlation had temporarily hit the levels currently seen in Europe on several occasions.

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Cheap equities: The upside to growth fears is cheap equity valuations. British hedge fund manager Crispin Odey reckons that European equities are "mouth-wateringly attractive".

Despite the geopolitical outlook being “unresolvably [sic] bad”, Odey’s latest bulletin cites high dividend yields and heavily discounted valuations as reasons to buy European shares. Odey operates one of the oldest and most successful hedge funds in London, recording annual gains of 17.9 per cent since 1992.

David Rosenberg and Jeremy Grantham, two strategists better known for their bearishness over the last decade, are also looking at Europe. Rosenberg said European indices were at valuations that mirrored the generational low recorded in America in 1982, while Grantham said global investors could “finally” build a “decent” stock portfolio for the long term.

This bullishness might puzzle investors concerned over the European economic picture. However, research shows there is little if any connection between economic growth and stock returns, with markets quickly pricing in future economic weakness. Today, they’re “pricing in a very high margin of safety”, Odey says.

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Buffet buyback:Warren Buffett has, for the first time, bought back shares in his investment vehicle, Berkshire Hathaway, prompting talk that US markets, too, are undervalued. The reasoning is that Berkshire has made so many investments in US companies; if it's cheap, indices are cheap.

However, it doesn’t stack up. Berkshire is trading at a book value of less than 1.1 compared to 1.9 for the SP 500. Buffett says the percentage of market capitalisation relative to US GNP is “probably the best single measure of where valuations stand at any given moment”. Buying stocks should prove profitable when market values are 70-80 per cent of GNP; currently it is about 90 per cent.

Buffett has never repurchased stock because he has always been able to locate better opportunities elsewhere. The argument that a stock buyback is a vote of confidence in the overall US stock market is tenuous, to say the least.