13 January 2012 at 9:02 GMT
Life is like an ocean voyage. Some days the sun shines, others it rains and in rare cases Poseidon demonstrates his wrath. In order to navigate in this world we need a compass. As we head into the perfect storm, we introduce an investment compass to better embrace the uncertainty and avoid the white noise clouding our minds. Instead of trying to forecast the next three months we will instead provide a 10,000 feet perspective on equities.
Equities are historically cheap but are they worth buying?
Global equities measured by our valuation model are relatively cheap in a historical perspective due to record low debt leveraging in companies and benign valuations. One factor that is dangerously high is return on assets driven by historically high profit margins as high returns on assets normally precede a plunge in aggregate profits. Given the massive excess capacity in the labour force and recent downward pressure on commodities, we believe companies can maintain current profit margins in the first six months of 2012.
Based on current valuations, a setback in the first half of 2012, due to political and economic developments in Europe, would not be outright bloody as equity markets have already adjusted valuations for a low growth scenario and more turmoil in Europe.
Our index valuation model on the S&P 500 below indicates a 2012 year-end level of 1,215 based on an Earnings Per Share (EPS) of 104.5 and Price Earnings (P/E) of 11.6. Given the current data equities are in aggregate terms poised for a flat year in our base case scenario with most downward pressure expected in the first six months as the earnings yield is likely to increase reflecting a contraction in growth expectations.
However with historically decent earnings yields and other asset classes providing no income stream to speak of, we believe a net neutral equity position1 is attractive going into 2012.
Are equities close to a low point before a secular bull market?
Investors are in a thick fog with low visibility and many are scared about the future of equities. While humans can certainly be too optimistic and they can also certainly be too pessimistic, we definitely tilt towards the latter at this point in time.
The chart on the next page compares the current CAPE (cyclically adjusted price earnings – price over the last five years’ of earnings) on the S&P 500 with the following 10-year annualised return since 1958. It shows that we have entered a valuation range that is normally a very good starting point for a secular bull market with good probability of delivering more than a five percent annualised return.
The chart below shows the prediction interval of the regression, which shows that since 1958 equities have never returned below zero percent (annualised over 10 years) if investors bought at these current valuations. In other words, if we enter the perfect storm and stock prices plunge even more we might be in a perfect low point before the next secular bull market.
White Noise: Investors' #1 enemy
Investors tend to forget that equities reflect the underlying nominal growth of the economy. Thus as the monetary base and productivity are continuously growing we would expect equities to trend up, adjusted for the business cycle over the long term. Stocks can temporarily experience negative real rate returns though.
The chart above shows the helicopter perspective on the trend in earnings, price to cyclically adjusted earnings and forward 10-year annualised returns. Despite energy crises, wars, terrorism and financial crises the human race and asset markets continue to move forward. What we want to demonstrate with the chart is that given the current earnings cycle in relation to price, there is a high probability of good long-term returns. In the short-term though volatility can be high which is why we recommend a neutral position at this point. Yes the Eurozone is seeing cracks and China might be experiencing a bust in real estate but these would not be the first asset markets hiccups in history.
The biggest risk to our compass (built on data since 1958) is that the current deleveraging is a replay of the 1930s Great Depression where the economy and stocks will significantly deviate from the trend to the downside.
If the storm hits, how deep can equities go?
According to our investment compass going back to 1958 the lowest 20 percent observations on price to cyclically adjusted earnings have been between eight and thirteen. If the markets enter the perfect storm could stock valuations fall into that range? Yes it is plausible and the agnostic bet would be mid-point in the range which is 11.5 times cyclically adjusted earnings. With the current five years’ earnings cycle of 77 per share in the S&P 500 that would imply an index price of 890 or a decline of roughly 28 percent.
More realistically we believe the ultimate floor lies around the price point when the present value of growth opportunities is zero thus the S&P 500 valuation is the present value of a perpetual stream of current cyclically adjusted earnings discounted with an eight percent required return on equity; this would imply a floor round 960 in the S&P 500 or a decline of 23 percent from current levels. Put very simply if we go below 1,000 in the S&P 500 investors should probably begin to aggressively invest in equities as the future will most likely deliver more than zero economic growth.
Download the entire Saxo Bank Q1 Quarterly Outlook.