The bubble bursts

24 April 2008

Just When it Looked Like the markets would start setting all-time records, the bubble of recent months burst in spectacular fashion in week 20. The trigger was higher than expected inflation figures in the US, which could provoke the Federal Reserve to raise interest rates further, having previously signalled that the cost of borrowing would level-off. This threat to corporate earnings provoked a widespread sell-off of shares, first on the US markets and then to a much greater extent on other bourses around the world.

It is an interesting phenomenon that stock markets in Europe and Asia always react more violently to bad news in the US than its own investors do, but that's the way it was in mid May. Between weeks 16 and 21 the Dow lost a fairly moderate -2,16% in this selling spree. However, the same period same the CAC 40 lost -6,07%, the FTSE 100 -7,35%, the DAX Composite -7,52% and the Topix 500 a massive -9,45%.

Construction Shares

The picture was similar in the construction sector, with week 20 seeing the CET suffer its steepest ever one-week fall. It dropped from a record high of 192,38 points at the end of week 19 to 167,89, and finished week 21 at 166,85 points, -7,79% lower than it was in week 16. This fall wiped out all the gains made in the previous four months or so, taking the CET back to where it was in early February.

It was the equipment sector that suffered the steepest fall, losing -8,79% of its value between weeks 16 and 21. Only Palfinger and Volvo saw their shares rise over the five-week period, with the rest of the segment enduring some sharp drops.

The smaller niche companies seemed to come of worst from the selling spree, with Gehl, JLG, Kubota and Pinguely-Haulotte standing out with some of the largest losses. But alongside them there were also steep slides for bigger companies like Doosan, Hitachi and Sandvik, which had double-digit losses.

In a trend that was mirrored by the mainstream indexes, the European and Asian manufacturers seemed to suffer much greater losses than their North American counterparts, despite the reason for the sell-off emanating from the US. Odd though it seems, the slides for the major US players like Caterpillar, Deere, Ingersoll-Rand and Terex were limited to -5% or less over the five week period.

There were widespread losses among contractors' shares which saw the CEC Index lose -7,63% of its value to finish on 185,89 points. Just prior to the slump in week 21, both Bam and Eiffage split their shares to increase the availability of their equity, which reflected the buoyancy that had prevailed in the earlier part of the year.

However, when the sell-off came it saw 13 of the companies that make up the 24-strong index record double-digit losses. There was not any obvious geographic pattern to the worst affected equities, with French, German, Scandinavian, Spanish and UK groups all in the firing line.

The only bright spot was with Bouygues, which saw its shares achieve a marginal gain of +0,7% in the five-week period.

Things were not quite so bad for the materials producers. The CEM index lost out slightly less than the CEC and CEE, with a -6,83% drop to 139,83 points. All the companies in the index saw their stock falls, with Hanson, Holcim and Wolseley experiencing the most significant drops. Only Lafarge emerged relatively unscathed with a marginal -1,25% fall in its share price.

Currencies

Having held its value reasonably well over the last year or so, the US Dollar took something of a nose dive in May. By the end of week 21 it was valued at € 1 = US$ 1,284, a gain of +4,2% for the Euro since week 16. There are now serious worries the Dollar will fall much further, with the apparent weakness in the US economy having the potential to undermine the currency.

Unlike the previous fall from 2002 to 2004, when the Dollar lost ground predominantly against the Euro, its depreciation this time round has been more widespread, with sharp slides against both the Japanese Yen and British Pound. In the same five-week period saw the Dollar lose -5,2% against the Yen and -5,4% against the Pound, while its loss against the Euro (in Dollar terms) was actually more limited at -4,1%.

Needless to say, if the Dollar sinks further it could have serious ramifications. So many currencies around the world are pegged to the Dollar in some way or another that a sudden depreciation would be disruptive to global, particularly for exporters in Europe and Japan.

Outlook

On the surface, May's sell-off seems to be something of an over-reaction to the relatively minor hiccup of a blip in US inflation and the threat of a few more percentage points on the cost of borrowing. However, the issues are more complicated.

The markets have rallied so well recently that a lot of money has been made ‘on paper' from rising share prices. There is clearly a strong element of profit taking in the recent slump, with investors taking their money out of the market at the first signs of a downturn.

Profitability is still good in the construction sector, and it may be that shares recover after the initial panic. At the same time, those that sold in May could be proven to have made the right move if more data emerges to indicate an economic slowdown in the US and elsewhere.

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