Bargain hunt

Croesus/An investor's view:So now it is almost official that the US economy will go into recession during 2008, as economists at Wall Street heavyweight Goldman Sachs have come out predicting a recession.

Goldman chief economist Jan Hatzius expects a cumulative drop in gross domestic product (GDP) of 0.5 per cent over a period of two to three quarters. He expects the jobless rate to rise from 5 per cent to 6.25 per cent and is forecasting the first decline in consumer spending since 1991.

The US Federal Reserve is expected to respond by cutting the key fed funds rate to 2.5 per cent by the third quarter of 2008 from its current level of 4.25 per cent.

This is not yet the consensus view among American economists. A survey of 62 economists between January 3rd and 8th by Bloomberg showed that the median expectation is for economic growth of 1.5 per cent over the first half of 2008.

However, the probability of a recession occurring over the next 12 months is as high as 40 per cent, according to the median estimate of the economists surveyed.

Whatever about the diverse views of economists, action on the stock market over the early days of the new year indicates that many investors have made up their minds that a recession is imminent.

The S&P 500 and Dow Jones Industrial Average have each fallen by 5 per cent since the end-of-December close, while the technology-laden Nasdaq is down 8 per cent. The Japanese index has fallen by 5 per cent on fears that Japanese exporters will suffer badly if the US consumer stops spending.

Safe-haven assets such as gold and US treasuries have benefited from a flight away from risky assets such as equities.

The gold price recently hit an all-time high and the prices of US 10-year bonds have been driven to a level where they now yield less than 4 per cent.

With volatility in asset prices likely to remain high, 2008 is going to be an uncomfortable year for investors. Of course, for the long-term equity investor, this type of environment can present many opportunities as the prices of many well-managed companies can fall to levels that represent great value.

Finding such opportunities is not easy, but a starting point is finding those markets that are likely to contain a lot of undervalued stocks.

The table reproduces valuation statistics from the Financial Times for a selection of markets.

Those markets with a price-earnings (p/e) ratio of less than 10 are categorised as "cheap" and those with a p/e of more than 16 are categorised as expensive. For reference, the US equity market is trading on a p/e of just over 15 and the UK market is on a p/e of 11.5.

A striking feature of the "expensive" category is that the list consists mainly of emerging markets and eastern European markets. Markets with a p/e in excess of 20 include China, India, Russia and Greece. Brazil and Poland each have a p/e of just over 16.

These high ratings reflect the fact that money continued to pour into these markets in the second half of 2007 as investors sought to participate in the rapid economic growth being enjoyed by these emerging economies. Indeed, the pessimism induced by the credit crunch and recessionary fears in the US spurred increased investment flows into these markets.

In contrast, those markets with sub-10 p/e ratios occur in smaller developed economies that include Ireland, Israel and the Netherlands. Other inexpensive markets with a p/e in the 10-12 range include Belgium, Norway, Sweden and the UK.

Closer analysis of the particular circumstances in each of these markets will reveal reasons as to why they are so cheap.

In Ireland's case, the onset of a property recession has led to fears of a sharp fall in economic activity during 2008. With housing output likely to halve in 2008, construction-related stocks fell sharply.

The drop-off in mortgage demand and concerns that bad debts may rise also hit financial stocks.

Furthermore, the overall negative sentiment exerted downward pressure on many other stocks listed on the exchange.

One conclusion from this analysis is that the search for long-term investment value is likely to yield better results if it concentrates on markets that are closer to home.

The very low overall p/e ratios exhibited by several European markets, including Ireland and Britain, indicate that there are many inexpensively valued companies trading on these exchanges.

Although the currently faster-growing emerging markets may continue to do better in the shorter term, the better long-term opportunities may well be lurking in European markets.