Equities – is the bad news priced in?
By Neels van Schaik
One thing that remains true is that financial markets are incredibly efficient at discounting investor expectations. This essentially means that asset prices move in advance of information that “Joe Soap” gets to hears about. It is a point well illustrated in the attached graph, which compares the year-on-year change in the S&P500 (blue line) to the year-on-year growth in US Industrial production (red line).
Although equity price performance is much more volatile compared to a measure like industrial production, there is quite a strong directional relationship between the two variables. What is also evident is that equity prices has led economic activity, as reflected by industrial production, by about six months (note that the blue line turns before the red line).
Equity prices have therefore already discounted a significant amount of bad news as seen through the sharp drop in the blue line into January 2008. Given the very bad economic data flow in the US during the last few weeks, we would not be surprised to see the last US announced GDP number of 0.6% being revised downwards, and industrial production will in all likelihood track equity prices lower.
This deterioration in the economic health of the US economy and the commensurate meltdown in US equity prices have taken a significant toll on equities around the globe. This is despite a previously held belief that growth in economies, especially emerging markets, would be unscathed by a US slowdown or even a US recession. It remains to be seen how this theory will play out, but what seems abundantly clear is that when sentiment turns negative, there is no place to hide.
How deep and prolonged the slowdown in the US will be is a mystery, but what is evident from the graph is that US equities have already priced in a severe slowdown in growth. This is in line with the profit squeeze currently unfolding in the listed US corporate sector, albeit that the problem is disproportionately skewed by the disaster in US financial profitability and the market has a heavy exposure to financials.
So, whilst sentiment is horrid and might stay this way for a while, what interests us is that the price-to-earnings ratio on the S&P500 has de-rated to 1995 levels despite the massive profit increases we have seen during the last few years. This again talks to a market’s ability to discount news.
Of course the argument can be made that the rating can still decline to 1991 levels, which is when the US last had a recession with a similar backdrop to the current one. If this transpired, equity ratings (price-to-earnings) on the S&P500 could still drop another 10% to 15%. To occur it would require share prices falling further, or share prices absorbing earnings and de-rating further or a bit of both occurring simultaneously.
Uncertainty created by bad sentiment is the name of the game at present, and further wild swings in equity returns during the next few months is probably on the cards. But from a fundamental point of view equity returns in the US have already discounted a lot of bad news and we think that the continued monetary policy easing by the FED will assist markets in the medium term to stabilize.
Unfortunately, South African equities have not been unscathed by the events globally, and while global investors grapple with the recovery path of the US economy, and more specifically the financial sector, local equity price performances will remain volatile. As the US markets have been winding down their P/E’s, many local companies have been de-rating too. In fact, some South African companies are now on ratings last seen during the profit recession in 2001/2002. For many of these companies, profits are likely to slow further from current levels; profits are being impacted by electricity shortages and the last couple of interest rate hikes during 2007. But here too, market efficiency has impacted brutally and much of the bad news has been priced into many SA stocks.
What will count going forward is two things. Firstly, that investors accept that certain local companies are cheap and worth buying. Secondly, that the investors will have the guts to deal with extreme doses of bad news and accompanying share volatility over the short-term, in order to enjoy superior long-term returns.
Source: Neels van Schaik, Alphen Asset Management, February 8, 2008.
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