Economy is bad, but stock valuations aren’t: Report

The world is in a deep global recession that’s expected to continue until at least the end of this year, but that doesn’t mean the markets aren’t rife with opportunity, according to the latest Global Investment Outlook by the country’s largest asset manager, RBC Asset Management.

According to RBC’s 70-page spring investment outlook, authored by the firm’s Investment Strategy Committee, signs of an economic turnaround won’t appear until later this year. But in the meantime, the market is offering some of the most compelling valuations in more than a generation.

“There are two crises going on. One is the crisis in the financial system. The other one is the entirely related deep recession in the economy. The second one we all understand very well; even the public does — it’s a worst case of places we’ve been before. The first crisis is really tough to understand. Fixing the economy is dependent on [fixing] the financial crisis,” Dan Chornous, the chief investment officer for RBC Asset Management tells Advisor.ca. “If you could put the financial crisis behind, fairly quickly comfort would return to investors. Stocks have been at an unusually attractive level relative to their fair value. As you gradually or even quickly move confidence back in, you move stocks back to their fair value.”

RBC has created some statistical models using historical price-to-earnings (P/E) data from stock market indices to get some sense of what “normalized” returns would be, based on the earnings expectations of stocks during the stabilized periods of a business cycle.

Chornous points out in the report that the midpoint of the P/E band of the S&P 500 over the last 50 years is now 17.3x earnings. If investors were to capitalize profits at their average long-term level as established by RBC’s normalized estimate, the S&P 500 would essentially be discounting an earnings drop of 56% from its July 2007 peak.

“In the current environment of intense fear, though, the bottom of the normalized P/E band may represent a better estimate for the appropriate multiple. Using a multiple of 13.4x, equities are already discounting a 43% drop from peak earnings,” he says. “It could, of course, get worse. There is a significant chance earnings could fall as much as 50%. If we traded at 13.4x earnings down 50%, that would imply we could see the S&P 500 trough at 617.”

The S&P 500 is currently not too far from that mark; that means a bottom in equity valuations could be near.

According to RBC, trend level earnings for the S&P have compounded at 6.7% over multiple decades. During periods like the decline of the tech bubble in the late 1990s, earnings far-outstripped this, but they were rapidly corrected in a deflation of stock prices. RBC doesn’t see why this trend wouldn’t continue over an entire business cycle.

“Consequently, we believe that 6.7% is a good estimate of S&P profit growth through a full cycle, regardless of the swings that occur in between. Extrapolating the natural course of the market using that analysis, the current number is $80 [per share] for 2009 (the intercept for 6.7% compound annualized growth rate in 2009),” Chornous says. “If you apply a conservative 13x to 14x P/E-multiple on that trend-earnings expectation, this would imply an underlying S&P target of nearly 1,100. Even applying a 10x P/E multiple, which is two standard deviations below the norm — which should be seen about 2% of the time — would result in an 800 target for the S&P.”

Chornous says investors can also look at the yields on corporate bonds to get some sense of whether things are stabilizing for companies. Many advisors and investors are moving to these asset classes to implement pay-to-wait strategies.

“There is an unusual risk in high-yield bonds, because there is unusual risk in the economy. If you think of spread on high-yield bond as being a measure of risk premium, there has been a massive adjustment in the risks that are priced into bonds,” he says. “We are seeing the probability of bankruptcy in the modern era. There is a chance that those are delivered or even a chance an even worse experience is delivered, but not that large a chance as the market reflects.”

He says history suggests risk is probably also priced into equity prices, since both asset classes are correlated to corporate earnings.

“Many people think that the credit markets have to bottom before the stock markets bottom. I’ve done work with the stocks, and sometimes they do and sometimes they don’t. The bottom is usually contemporaneous and it ought to be, because both of them are affected on the outlook for corporate profits. That changes at the same time for everyone. [Earnings] will either widen or narrow risk premiums, making stocks go up or down or spreads go up and down,” he says. “If we believe that we have seen the lows for corporate bond prices, you can be fairly comfortable that we have seen the bottom for stock prices as well, because they both depend on corporate earnings. Both are at extreme levels of valuation relative to history.”

Chornous says the S&P 500 is as oversold as it has ever been, the only comparable experiences being in 1974 and 1932.

“In fact, less than 10% of S&P 500 stocks have positive price momentum. Market bottoms tend to form with this statistic below 20%, a level first achieved way back in the fall of 2007,” he says. “There is also a tremendous amount of cash on the sidelines and it continues to mount by the day. It is only a matter of time before part of this money will become impatient with the guarantee of little more than zero percent real returns at best, and push back into risky asset classes. The resurgence of corporate bonds is a recent case in point.”

Patricia Croft, the chief economist for RBC Global Asset Management, points out that China is one those players with a lot of cash. This throws a different dynamic into global recovery scenarios, because China could lead the way out, changing assumptions of what a recovery might look like.

Croft notes that the Chinese government has pledged $586 billion US in fiscal stimulus, equivalent to roughly 14% of the economy. However, unlike the U.S., China has the ability to readily finance aggressive policy measures, since its debt-to-GDP ratio is 19% and it has foreign exchange reserves of more than $1.3 trillion US.

If the Chinese economy gets back on the rails, it’s likely that commodity prices would do so soon afterward, as it continues its massive infrastructure and industrialization projects. This could create challenges, though, for economies like the U.S., which are currently enjoying lower commodity prices to offset some recessionary pressures.

“The difference with China is it has very deep pockets. It’s a command economy. If the government says they are going to have 8% growth, they are going to have 8% growth. The banking system is fairly sound. The purchasers/lenders index is at 49%, very close to that key 50% level. There are signs China is beginning to revive, and I think we will see improvements in the Chinese economy well before we see improvements in North America, Europe or Japan,” she says. “It certainly could [cause price differentials]. One of the things we’ve seen is supply destruction in the commodity markets, with projects in the oil sands and mining sectors being delayed or postponed. This could set the stage for strength in commodity prices when things come back.”

(03/12/09)