We're out of Depression trajectory

PORTFOLIO POINT: Markets have pulled out and could rise by 30%, but the rally will not go on indefinitely.

Better macro data suggests that, barring a new tail risk unfolding, the cycle low for real economic activity is within sight. That justifies some improvement in risk markets. There will be recovery! Sustaining the rally depends on the answer to a different question: What sort of recovery will it be? Indeed, does the likely recovery justify even the improvement seen already in risk markets?

It's unalloyed good news that the period of economic free-fall seems to be over. Markets were never going to stabilise until investors got a fix on the depth of the real cycle. A macro inflection point gives them that fix.

Remember, however, that the alternative (ongoing free-fall) was never fully priced in, even though several indicators were literally on a Great Depression trajectory. Exhibit 1, for example, shows that US exports fell faster from their peak in this cycle than they did from the 1930s peak. I don't have the data to check, but my hunch is that the collapse in industrial production in, say, Japan, was of a Depression trajectory.

In other words, if there wasn't an inflection point, we would be heading towards Great Depression 2 – an outcome considered a tail risk, perhaps, but clearly never investors' (or markets') base case. Even now, tail risks remain, notably surrounding the still-fragile Western banking system. That risk is not trivial, in my view.

We are now seeing more than just avoidance of a Depression. The improvement in risk markets is spreading to credit (Exhibit 2). This was something that most, myself included, saw as a precondition for sustainable improvement in equities.

So the issue for investors has changed: it is no longer assessing where the cycle floor is; the key issue now is making a judgement call about the recovery.

Our macro team's view is that the recovery in developed economies will be relatively slow coming, and will face significant headwinds. On that basis, our equity strategists remain cautious on the big picture: The prospect for earnings recovery is still too far away (and current forecasts still too optimistic) to believe that a new bull market has started. I agree.

Take the US as an example. Exhibit 3 shows quarterly earnings per share forecasts. The bottom-up consensus expects that earnings will be back almost to their peak by end-2010. Such a V-shaped earnings rebound would typically be associated with a V-shaped rebound in the real economy (Exhibit 4).

Our view, however, is that the consensus view underestimates how far operational earnings are likely to fall (remembering that for non-financial earnings the cycle peak was only the September quarter last year) and that the tepid recovery will lead to a muted earnings rebound.

Three points about this: First, the focus on recovery means a focus on 2010 earnings. This takes the sting from weak 2009 earnings.

Second, if the 2010 earnings forecasts are anywhere near correct, equities are cheap. Exhibit 5 shows the S&P 500 with price/earnings bands based on two-year-ahead consensus forecasts. Having traded around 14 times two-year-ahead earnings through the bull market, equities de-rated to 10 times in the first half of last year, then (after Lehman's collapse) tracked earnings downgrades lower. The market is now on around 11 times two-year-ahead forecasts.

Third, the rub for still-cautious strategists, such as myself, is this: It's not clear what the near-term catalyst will be for the out-year earnings forecasts to be significantly scaled back. It seems likely that earnings downgrades will moderate as long as the macro data continues to surprise on the upside (even if, in absolute terms, the data remains poor). That opens a window for the current rally to continue, driven by investor repositioning.

The rally, however, will not go on indefinitely. Rising markets will tip the burden of proof. With the S&P 500 at 700, the macro data had to remain horrible for the market to keep falling. Conversely, if, as I expect, the market heads higher, investors will increasingly need to see data that validates the solid earnings recovery now forecast.

Gauging when the market has reached a level where the risk-reward flips to the downside again is an art, not a science. However, my line in the sand has been at an S&P 500 around 950–1000. That, as Exhibit 5 shows, would be consistent with the market being on about 13 times two-year-ahead earnings.

Gerard Minack is chief market strategist of Morgan Stanley Australia.