A wrong call on equities

I was too bearish on equities before … but they’re no longer cheap.

PORTFOLIO POINT: Central bank policy action has driven up equities. But I think earnings downgrades will cut the rally short.

We have been too bearish equities this year. Earning forecasts are down, but valuation (PE) is up. It matters why we’re wrong: if the rising PE predominantly reflects the power of central bank policy, then the prospect of ongoing policy intervention would be a powerful bull point for stocks.

However, I think a range of factors was at work. At current valuations, with downside risk to earnings, I doubt that the equity rally, at least for developed markets, will persist into next year.

Most major equity indices are up 10-20% over the year to date. I was wrong to be cautious. Paradoxically, consensus forecasts for both economic growth and earnings have fallen through the year. Consensus EPS forecasts for 2012 have fallen by 8% this year for developed equity markets (Exhibit 1). The rolling 12-month-forward earnings series is little changed over the year because the (higher) 2013 forecast gets a greater weight than the 2012 forecast as the year progresses.

With indices up and earnings down, valuations must have increased. The prospective PE on the DM MSCI index reached 12.7 in mid-September, up from 10.7 in early June, and 9.5 in October 2011. The 30% rally in DM equities from the October 2011 low to the September 2012 high is due to a 34% PE expansion.

If this PE expansion largely reflects policy action by central banks, then the promise of additional unconventional policy support points to further gains for equities. However, I’m not convinced that central bank policy was the only, or critical, factor.

First, real macro data have affected the PE. Exhibit 2 shows the correlation between the prospective PE and macro surprises in the G10 economies. Of course, macro surprises mean-revert, while the PE need not.

Second, valuation was attractive at last year’s low. I believe equity valuations will be lower going forward relative to the past 25 years (average PE since 1988 is 16.25), but under 10 times on a forecast PE is cheap.

Third, while central bank action has been supportive, the correlation between policy announcements and equity market behaviour is loose, particularly outside the US. More to the point, Exhibit 3 shows that DM equities excluding the US have moved sideways for the past three years. The flat trend is despite the unconventional policy measures undertaken by non-US central banks (notably, the BoE, BoJ, SNB and ECB).

Superior US performance may reflect greater aggression by the Fed. However, earnings fundamentals also support US outperformance. US corporate earnings have continued to rise since 2009; in contrast, earnings elsewhere have rolled over (Exhibit 4 shows operating EPS).

Likewise, forecast earnings have been more resilient in the US than elsewhere. Consensus estimates for 2013 S&P500 earnings are little changed from the start of this year, while other markets have seen material downgrades (Exhibit 5).

Earnings explain the US market’s superior performance. But my mistake was to underestimate the PE expansion. The US market has maintained a valuation premium throughout the rally (Exhibit 6). However, the PE expansion has been more significant elsewhere: the prospective PE on the Euro-stoxx expanded by 33% from early June to mid-September, compared with 16% for the S&P500. (Within Europe, the PE on the IBEX is up 66% and Milan is up by 44%.) In short, the significant factor in the PE expansion was the re-rating outside the US (although I did not expect the US PE to rise).

I have been too cautious this year. In hindsight, I should have recognised the valuation attraction of equities a year ago, and superior earnings performance of US stocks through the past year. Central bank action has also been supportive, notably in Europe, which has seen the largest valuation gain (from distressed valuations levels).

Amidst this mix, QE has probably played a role, but I do not think it is decisive. Looking ahead, equities no longer appear cheap, in my view, and I expect material downgrades to 2013 EPS estimates in Europe and the US. I doubt that central banks can prevent markets from responding to these weakening fundamentals.


Gerard Minack is head of global developed market strategy at Morgan Stanley.