Croesus/The Investor's View:The carnage of the last month has inspired apocalyptic talk from many a market observer. Still, the old market adage that one should buy when there's blood in the streets contains more than a little wisdom.
Croesus thought it might be time to take a peek at some overlooked positives and analyse where the gains are likely to come from in the coming months.
From a contrarian perspective, the recent action suggests that a near-term bottom may have arrived. Before the rally occasioned by the Federal Reserve's half- point cut in the discount rate last week, fewer than 10 per cent of stocks in the S&P 500 were trading above their 50- day moving average.
Readings below 20 per cent generally indicate a heavily oversold market and tend to occur not more than once or twice a year.
Single-digit readings are reserved for times of true panic - the last time a comparable reading was recorded was in the days following the September 11th attacks. Contrary to popular memory, the following months were very rewarding for investors, with a 20 per cent rally ensuing.
TrimTabs, a US investment research firm, recently estimated that small retail investors pulled almost $13 billion out of US equity mutual funds in a single week - the highest such outflow since the aforementioned September 11th panic.
Small investors have a reputation for awful market timing. Instead of being "greedy when others are fearful and fearful when others are greedy", to use Warren Buffett's memorable phrase, they tend to panic and to buy high and sell low.
As a result, there is a number of contrarian indicators that look at what the so-called "dumb money" is doing.
The same firm points out that the small investor has been suspicious of US equities for some time now, with outflows of $35 billion in the last four months. The last time such outflows were recorded was in 2002, at the very tail end of the global bear market.
Interestingly, the same firm estimates that managed funds aimed at institutional investors have been ploughing into US equities of late. In other words, the dumb money is selling and the smart money is buying.
Another way of determining what the smart money is doing is to look at the buying and selling activity of those in the know - company insiders.
Prof Nejat Seyhun, author of Investment Intelligence From Insider Trading and a leading authority on the subject, has compiled an "Insider Confidence" index that tracks whether company directors are buying or selling company stock. He says this index has an impressive record in predicting market returns over the following 12 months.
Readings for the first seven months of 2007 were in the "strongly bullish" zone, he told the New York Times in a recent interview.
As Croesus pointed out last week, market price/earnings (p/e) ratios suggest that stocks are far from expensive. The Iseq sits on a p/e ratio of 12.5 - below its recent historical average. In the US, the S&P 500 is trading at a p/e ratio of 15, roughly in line with its historical average.
Some US sectors look cheaper than others. A recent Bloomberg article pointed out that the much-maligned financial sector, which has been butchered of late, was trading "for 10.8 times profit, the lowest price/earnings ratio since Bloomberg began tracking the data in 1995".
Still, while markets are much cheaper than they were a month ago, there is no guarantee that further falls are not in store. All kinds of imponderables could yet come into play.
In any case, further falls should see a flight to quality - in this case, to large-cap stocks. The bigger, blue chip companies are looking cheap at the moment. The large-cap FTSE 100, for example, is trading at a p/e ratio of just 11 - its lowest since 1991 - in contrast to the mid-cap FTSE 250, which looks pricey at a p/e ratio of 16.5.
Small-caps have been outperforming the big boys for the last number of years, although the evidence suggests that investors were having second thoughts even before the recent volatility.
The FTSE 100, for example, rose by 8 per cent in the first six months of the year, almost double that of the FTSE 250. In the US, while the large-cap Dow powered ahead to new highs in June and July, the small-cap Russell 2000 remained stuck in a trading range.
The small-cap outperformance could not go on forever. Last March, it was estimated that the 50 smallest companies in the S&P 500 were trading at an average p/e ratio of 30 - significantly higher than valuations in 2000, when the market peaked.
In other words, a market rebound in the following months may not lift all boats. Similarly, a continued correction should see investors seek refuge in beaten-down blue chips.
