Analysts at leading US investment bank Citigroup have issued a dramatic warning to clients to be wary about the current state of the stockmarket.

Authored by analysts Adrian Blundell Wignall and Alison Tarditi, it warns that there are “similarities with the 1986-87” period leading up to the last big stockmarket crash.

Blundell-Wignall is a former senior Reserve Bank staffer who left to become an investment analyst. He is considered to be one of the most highly regarded macro-analysts in the country.

The report suggests that we “pray” that companies globally “restore fundamentals” and that we can avoid ‘major shocks’.

“Greed has become a factor and comparisons with elements of the late 1980s come to mind,” the report warns. It is concerned at “the cheering on of private equity deals that worry us”.

There are worries about the health of the US economy, the valuations of takeover stocks in Australia (such as in the media and retailing), worries that the listed property trust sector is over priced and a concern and that China is slowing(but this is not being taken seriously).

In their lengthy report, contained in Citigroup’s daily circular to clients, the authors state that their key points are:

  • The market is getting expensive again.
  • But the money is pouring into the equity market at rates that we have now revised significantly higher.
  • There are signs of excessive complacency about economic performance, and the cheering on of private equity deals, etc that worry us.
  • One of our key fundamentals (US productivity) has wobbled.
  • There are similarities with the 1986-87 market in relation to exuberance and deal making; but what if we are only early in that process? In the absence of a shock, it could go on.
  • We think it is a time for caution – play the ranges for now and pray that companies (globally) restore fundamentals and major financial shocks are avoided. Avoid stocks with abnormally high returns where signs of excess are apparent.

Also in the report:

Inflows into managed funds could be as high as $79 billion this year and $92 billion next year. Changes in super rules in the run up to 30 June 2007 as well as the creation of the Future Fund are responsible.

Compared to like issuance, there will be massive excess cash coming into the market in both years, and asset managers will benefit strongly (more than we previously thought)….

Moral hazard problems associated with private equity and the ready availability of liquidity, both here and globally, are driving up equity prices beyond reasonable returns, primarily in the Industrials. Greed has become a factor and comparisons with elements of the late 1980s come to mind…

The current period has some worrying characteristics in common with the late 80s and the LBO debacle: greed and deal flow are driven by…

Fees for private equity are related to deal size. Banks want to lend for the profitable business loan segment. Private equity benefits in the short run by inflated valuations of companies. Until one of the deals falls over, banks don’t have the incentive to impose tough loan-to-EBIT standards – there is excessive willingness to lend….

Signs of excessive exuberance are present in the form of: “generous” success fees for new floats, associated with excess volatility; directors granting themselves in-the-money options related party fees and transactions with cross directorships involved….

If any deals here in Australia, or abroad, start to go bad, lending standards will tighten, and the secondary market in deals will dry up. If transactors then turn to the stock market for funds, supply and risk factors would be negative for the market.

Despite the warning, the analysts do like resource stocks generally but are switching from some stocks into others in the sector.

This is a bit at odds with the worries about China, but then China is still growing, just a little more slowly.

 


 

Adrian Blundell-Wignall and Alison Tarditi, Directors, Australian Equity Strategy, Citigroup, write: In response to this article, we would like to clarify some points. In the report we are careful to point out there are both similarities and differences with the market from 1986-1987 to now, not simply similarities with October 1987. Deal making and flows are driving markets into the early stages of overvaluation. We point out that the market is about 10% above the level we think is fair on earnings etc, and that in ’87 it got to around 75% over-valued. The market could go on to more dangerous levels now, given the exuberance, which is why being out of the market could be as risky as being in it . The best way to play these situations is with caution, and certainly avoiding some of the very expensive stocks, of which there are now quite a few— this is surely a sensible thing to do. And yes, there probably is relatively less hot air in the diversified resource stocks.

Peter Fray

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