Buffeted on a battlefield of emotions

It has been a rollercoaster on the American stockmarket as two dominant moods – greed and fear – alternately hold sway. With many stocks still cheap, a little greed is justifiable at the moment.

It has been a rollercoaster on the American stockmarket as two dominant moods – greed and fear – alternately hold sway. With many stocks still cheap, a little greed is justifiable at the moment. Over the past few months, investing in the world’s largest, most vibrant, most diverse stockmarket has been by turns dispiriting and exhilarating. It has even, on occasion, been profitable. But it has rarely been dull.

With each new rumour, with every fresh piece of economic data, the mood has alternated, swinging from euphoria to despair and back again, sometimes within a matter of hours. More than once the Dow has closed hundreds of points down only to make up all that lost ground within minutes of the next day’s opening bell.

This volatility has not been driven by anything so dull as changes in corporate earnings, cashflows or profits, but by the tug-of-war between two opposing emotions: greed and fear. During bull runs, greed predominates; in bear markets, fear has the whip hand. But the type of volatility we saw during the summer only occurs when those two emotions are both powerful and evenly matched. And at the moment investors can find plenty of reasons to be greedy, and almost as many to be fearful.

The long commodities/short financials trade that has tended to prevail since the end of last year reached its apogee early in the summer: energy outperformed and financials underperformed. In this polarised market, almost anything “resource-related” did well. While this was, in many cases, largely driven by indiscriminate buying on the part of hedge funds, this greed was also justified by fundamentals – some companies in commodity-related sectors have seen their earnings estimates rising by extraordinary amounts this year. Equally, subsequent earnings announcements showed that the punishment meted out to financial stocks in June was also, on the whole, justified.

In July, however, we were reminded of two things: that Uncle Sam hates instability and that his pockets are very deep. This became apparent as speculation mounted over the ongoing viability of Fannie Mae and Freddie Mac – the twin pillars of the American residential mortgage market.

The Treasury intervened, propping up Fannie and Freddie, making their implicit federal guarantee explicit. To a market looking for an excuse to take profits on the long commodities trade and start scooping up cheap financial stocks, this looked like an inflection point. The earlier trends immediately went into reverse. Short covering saw bank shares moving sharply higher. In a mirror image of June, energy stocks fell by nearly 15% in July. Financials rose by 5%.

For investors looking for reasons to set aside their worries about the viability of American banks, the Treasury’s intervention came at a good time, neatly coinciding with a handful of better-than-expected results in the banking sector. Fearful that the Treasury might keep writing cheques to bail out struggling banks, leveraged investors covered their financial shorts. The rapid gains that followed – the banks index ended July some 37% above its level just two weeks earlier – occurred almost without regard to fundamentals.

Take Wachovia Bank. By almost any criteria its results were disappointing: it reported a loss of $8.7 billion (£5 billion), cut its dividend by 87% and suffered significant earnings downgrades. The market, however, responded to those awful results by sending its shares 27% higher.

What caused this extraordinary bounce? Less negative operating data than had been expected played its part, as did suggestions of “kitchen sinking” by Wachovia’s new chief executive officer. Suggestions that the bank might become a takeover candidate did not hurt. But while none of that made it a “buy” on fundamental grounds, Wachovia did have one great advantage: it fitted the new trend.

Another trend to emerge over the summer was the rapid appreciation of the dollar, which strengthened by 8% against sterling in August, turning a 1% return from the American market into a near 10% return to sterling investors.

While it may have been a coincidence that the start of the dollar’s rally coincided with a doveish quarterly Inflation Report in Britain, that report neatly underlined the fact America is not alone in facing slowing growth.

Heading into 2008, we predicted that the greenback’s long decline would come to an end. That prediction proved correct. While the slowdown may have had its roots in the American residential property market, our globalised financial system has ensured that the pain has spread, first to Britain and, more recently, to the eurozone. The European Central Bank will eventually have to cut rates, and the interest rate differential, which has propped up the euro for so long, will narrow.

But while a tailwind from currency appreciation is nice, there are other reasons to view America in a favourable light. First, many American stocks are cheap – too cheap. Some of the commodity-related names are, after their recent underperformance, trading at a 50% discount to net asset value. That is unsustainable.

Is it, then, time to be greedy? A bit of greed is appropriate, certainly, but that should be tempered by a healthy dollop of fear. In particular, we do not believe that the time is right to rush headlong into American financials. The quasi-nationalisation of Fannie and Freddie may have temporarily neutralised one problem, but there remains plenty of bad news elsewhere in the system – witness, for example, the sad decline of Lehman Brothers.

On balance, however, we do err on the side of greed. America is an attractive defensive option: all the negative news on slowing GDP growth has already been factored in by the market. On aggregate, American stocks are trading on less than 13 times prospective earnings. That is, historically, very cheap. Plenty of these cheap companies have highly visible earnings. There are reasons to be fearful, but far fewer than there are in many other developed markets. And there are a lot of reasons to be – selectively – greedy.