Time to take

Canadians with the nerve to invest near the bottom of the market in March have been rewarded, but returns have come so far, so fast, some strategists are suggesting the risk on some assets now outweighs their earnings potential.

In early March, there was essentially a fire sale in risky assets, such as corporate bonds and equities, despite the fact the house had not burned down. Norman Raschkowan, chief investment officer for Mackenzie Investments was among the chorus of investment professionals during the downturn urging investors to put prices into historical perspective, which suggested there was too much risk priced in. He felt then that many securities were offering great buying opportunities.

With a huge run-up in riskier assets, particularly resource stocks and emerging markets, Raschkowan now suspects the pendulum has swung too far toward optimism.

As is typical of bear markets, riskier assets were hit the hardest, and as the economic expectations of investors stabilized, they had the most upside potential. Most of that under-pricing has been more than offset in the latest rally. Raschkowan is advocating investors look to rebalance more of their long-term target asset allocations, with a view toward higher quality assets.

“We’ve moved from a depression scenario that people were focused on in February and March to a view that at worst it’s going to be a recession — some people are feeling we are very much at the end of this recession,” Raschkowan says. “I think the growth coming out of this recession — probably around 2% to 2.5% — is very weak in terms of post-recession history. That suggests that the earnings growth estimates people have for 2010 are probably overdone, especially for the more economy-centric areas such as the resource sectors where you have seen very strong growth in the share prices in the last few months. I think it’s time to take a little bit of risk off the table.”

Raschkowan emphasizes while things are likely to improve, they aren’t likely to return to what they were. Investors have to remember that much of this financial meltdown and the recession that followed are the result of a de-leveraging process of the global economy.

With leverage taken out of the equation, the earnings potential of many companies is expected to be muted, when compared to the past.

“Leverage is coming out of the financial markets but it’s also coming out of the underlying economy. It’s one of the reasons that growth will be subdued,” Raschkowan says. “There’s a new prudence that’s going to be reflected in retail spending. People are not going to spend more than their earnings. [We may see] savings revert to what they were in 1970s, the 6% to 8% range. During the credit bubble, we saw people’s income growing at 4% a year and their spending growing at 6%. Over the next few years, income may grow at 3.5% a year but spending may only grow only at 2% a year.”

Muted earnings expectations Without leverage to juice up earnings, investors will have a real challenge when investing, in particular when trying to establish whether the price-to-earnings ratio on stocks is in line with earnings expectations after an economic recovery.

Generally, in a low-inflation environment, interest rates are low as well, and both point to a higher multiple, according to Andy MacLean, CFA, director of private client investing for Richardson Partners Financial’s and Clancy T. Ethans, CFA and chief investment officer of Richardson Partner’s Financial, in their latest MarketPoint report.

“The old rule of 20, which maintains that the rate of inflation plus the market multiple should add up to 20, argues for a high multiple today. With a current inflation rate of about 2%, and a market multiple of 15, the multiple could expand by almost 300 basis points,” they write. “Consensus S&P 500 earnings estimates for the year ended December 31, 2009 stand at $58. However, when looking at price targets for an equity market, nobody cares about what has happened but rather what will happen. So, investors are looking for what earnings will be at the end of 2010 in endeavoring to price what equities are worth in 2009. The consensus estimate for 2010 is $72.”

Is that a reasonable target? Ethans and MacLean suggest economic data has to improve before those kinds of multiples become attractive.

The economic numbers, such as manufacturing, employment and housing, must begin to trend from slowing their pace of decline to actual growth. Furthermore, the availability of business and consumer credit must increase and not just be available to the banks,” they note. “Corporate bond spreads must also continue to shrink back to their pre-credit crunch levels as a signal that implied default rates are coming down.”

They add, “We have already seen the transition from Armageddon to green shoots but in order for the rally to take equity indexes to the next level, we must see earnings visibility and earnings upgrades give way to strong positive earnings momentum.

Raschkowan, says he’s looking at companies with strong “internal growth” prospects to generate revenue, such as a pre-existing strong market position or solid presence in higher growth economies such as the Asia-Pacific region. These companies will be better positioned for a higher rate of earnings growth when a recovery takes hold.

Raschkowan highlights that even if earnings improve a further 25% in 2010, investors are still looking at earnings that are 12% lower than what they were in 2007.

“Companies are going to face higher interest costs on their borrowings. Governments are going to have to deal with fiscal rates. I think it’s fair to assume tax rates on corporations are going to rise over the next few years,” Raschkowan says. This is the very reverse of what they experienced over the last few years. Right now, you’re looking at a more modest earnings growth environment than the consensus expects.”

(07/20/09)