There is an old Wall Street saying that equity markets climb a wall of worry. Given the issues facing stocks right now, the hurdle is the size of the Great Wall of China. Stocks face a formidable list of headwinds: credit market illiquidity and investors unwilling to take risks; slowing economic backdrops across the developed markets ranging from a potential but likely recession in the US to weak growth in Europe and Japan; and most importantly slowing earnings growth.
An analysis of past US recessions reveals that the market turns negative well before a recession begins. It hits bottom while the data still appears bad, and is making a recovery on average 10 months after the recession was said to have started (data courtesy of Ned Davis Research). However, our concern is that this recovery will take longer than that. The current slowdown has been caused by financial failure and a real estate bubble rather than manufacturing. The result is that it will take time for the system to stabilise consumers to repair their personal balance sheets, and profits to normalise before they can push stocks higher.
Waning earnings are just beginning to be priced into the equity markets, albeit very slowly. First quarter estimates have been slashed significantly, mostly in the financials and consumer discretionary sectors, and even these reductions have come only recently. Bottom-up estimates still appear overly optimistic and reasonable equity valuations become less so when earnings growth is questioned.
The earning expectation for 2008, currently at 12 per cent, is still too high. So until slower growth is fully accounted for, stocks will be challenged to have a meaningful long-term advance.
It’s important to look for veiled signs of recovery rather than the obvious signs of doom and gloom. Historically, equities recover in advance of the economic signals. A rebound may not be immediate based on the concerns previously noted, but it will come. A return to normalcy within the credit markets will be necessary for people to be willing to take risk in equities.
There have been some initial signs that this is happening, but much more needs to come. Rationalisation that profits and margins need to be lower will be a good sign.
Daniel Farley, managing director, and head of US global asset allocation, State Street Global Advisors.
