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OPINION

A sense of perspective

A sense of perspective
September 1, 2015
A sense of perspective

That's well worth noting because it's clear to me that the US economy remains in fine shape and is in no way close to danger level. In fact, the respected Conference Board’s consumer confidence index soared 10.5 points to 101.5 last month, not only smashing expectations, but reaching its highest level since the turn of the year. New housing starts data continues to improve on the back of better labour market performance, hardly a sign of waning consumer confidence either. It's worth remembering that the US consumer accounts for around 70 per cent of the country's GDP, and 90 per cent of the economic activity is domestic.

Bearing this in mind, the revised second-quarter US GDP growth data came in at 3.7 per cent at the end of last week, a half a percentage point ahead of expectations, and economists are pencilling in at least 3 per cent growth in the third quarter, too. For US equities to enter a bear market, the economy has to reverse markedly from this point and that simply is not a realistic possibility right now. That's important for investors on this side of the pond because there is a high correlation between the performance of both our stock markets, hardly surprising given that the US and UK are major trade partners.

That's not to say that markets and Main Street don't decouple from time to time. This is part and parcel of bull markets. But these are separations that end amicably rather than in a permanent divorce. We have been here before. For instance, when global stock markets crashed in October 1987, the US economy was growing at annual rate of 6.8 per cent in real terms and continued to grow strongly thereafter. The steep share price declines represented a buying opportunity, not the precursor to a savage bear market.

The same was true in the summer of 1998 when equities fell by a fifth, spooked by the Asian crisis and the Russian bond market default which bankrupted hedge fund Long Term Credit Management and led to major intervention from the US central bank. In the same quarter, US economic growth accelerated to 5.3 per cent on an annualised basis. Again, the decoupling was a buying opportunity to exploit as global stock markets entered their final and most profitable stage in the run up to the dotcom bubble.

No more than a bull market correction

As chief economist and strategist Dave Rosenberg of Canadian private wealth management group Gluskin Sheff wisely points out, there have now been 15 pullbacks of a magnitude of 5 per cent or more in US markets since the current bull market started in March 2009, and on each of the previous 14 occasions the correction proved to be a buying opportunity. I believe the current one will prove no different. The average peak-to-trough fall in the S&P 500 has been 9 per cent in the previous 14 corrections, with four declines above 10 per cent including two close to 20 per cent. The current peak-to-trough decline in the S&P 500 index was 12.5 per cent at the low point last Monday. This correction looks nearer the end than the beginning.

Of course, I am under no illusions that the slowdown in Asian economies, a subject I covered last week ('Stay calm', 25 August 2014), will have some impact on western economies in the US, UK and Europe. But again we need some perspective here as the Pacific Rim export share of US GDP is the same today (6 per cent) as it was back in the Asian crisis in 1998. The US economy is no more exposed now than it was then. Indeed, roughly two thirds of the revenues of S&P 500 corporations are derived from within the US economy, and a meagre 8 per cent originate from Asia.

It’s a similar story in Europe as exports from the eurozone to China account for only 3.1 per cent of the region's total exports and around one per cent of GDP. Germany is the most exposed with its share roughly double those averages, but it’s still worth quantifying the likely economic impact of an emerging market slowdown on western economies.

Impact on consensus EPS estimates

Analysts at investment bank UBS estimate that every one percentage point fall in emerging market economic growth, including China, would wipe between 0.2 and 0.4 percentage points off eurozone GDP growth. There would also be secondary effects from the US as they feed back to Europe, so the aggregate effect could be higher than 0.4 percentage points.

So on the basis of consensus eurozone GDP forecasts of 1.5 per cent growth this year, and 1.8 per cent in 2016, UBS's strategy team reckons that current pricing in European equity markets is assuming an economic slowdown in China and emerging markets in the order of four percentage points off GDP growth rates, enough to lead to a mild recession in Europe in 2016. It is also consistent with a 20 per cent reversal in eurozone earnings estimates against consensus of a 10 per cent growth rate in 2016.

My own view, and that of UBS, too, is that this is too pessimistic as the US economy has proved far more important for European corporate earnings than domestic GDP, or exports to the Pacific Rim. As I have pointed out, the US is nowhere near the danger zone. Also, if the true GDP real growth rate in China in the first half of this year is "probably below 5 per cent", as economists at US investment bank Citi believe to be the case, rather than the official rate of 7 per cent, then the Chinese slowdown has yet to have any discernible impact on core eurozone corporate earnings.

In fact, a breakdown of the constituents of the broader Stoxx Europe 600 index, which represents large, mid and small capitalization companies across 18 countries of the European region, clearly shows that the eurozone earnings estimates have held steady. Pessimists will raise the valid point that forecasts will drift down in coming months given the lagged impact of global growth concerns, and the rapid equity market sell-off. But if the eurozone economy held up so well during the China and emerging market slowdown in the first and second quarters, then surely this would have already showed up in the earnings data already?

Amid all the doom and gloom it also seems to have been lost on some that the recent sharp falls in the oil price is tantamount to an economic boost to the eurozone. Analysis by the European Central Bank (ECB) shows that every 10 per cent decline in the price of black gold boosts the region's GDP by 0.08 per cent in the first year, a cumulative 0.19 per cent in the second, and 0.24 per cent in the third year. Brent Crude has fallen by a third since the end of June this year.

Furthermore, the slide in commodity prices is positive for corporate margins, too. European companies are also likely to enjoy the current benign credit environment for longer than previously expected as economists have sensibly reined in their inflation forecasts to around 1.5 per cent by the end of next year - to factor in the deflationary impact of commodity price falls - which increases the chances of the ECB running quantitative easing (QE) programmes for longer, too. In other words, the combination of an accommodative policy response by central banks to an emerging market slowdown, coupled with lower commodity prices, should contain some of the economic damage.

The most important point is that following a 19 per cent peak-to-trough fall in the Stoxx Europe 600 index, market pricing is far too risk averse even if the aforementioned scenario pans out. That's because the index is currently being priced on 14 times forward 12 months earnings forecasts and offers a 3.7 per cent fiscal 2015 dividend yield.

Valuations in perspective

Indeed, to put current valuation into some perspective, if you take the cyclically adjusted price earnings (CAPE) ratio which takes the current price and divides it by the average earnings of the Stoxx Europe 600 index over the past 10 years, then on this measure the current valuation is a thumping 20 per cent below its long-term trend. That's a sensible thing to do because earnings growth has been close to zero in the eurozone for almost five years, so earnings are still depressed. And this is not the only measure on which the market appears undervalued.

Analysts at UBS also calculate that the difference between the long-term trend for earnings of the Stoxx Europe 600 index and the current PE ratio also suggests a 20 per cent valuation discount. The point being that in the past 20 years the gap between the two has only been more extreme at major market troughs in both 2003 and 2009, and not by that much more than the current valuation gap.

I would flag up another contrarian indicator, the well followed Investors Intelligence bull-to-bear spread. This is derived by canvassing the views of investment advisers as to their current bullishness or bearishness in a weekly survey. In the last poll, the bull-to-bear spread had a reading of only 9.1, the lowest level since October 2011. Interestingly, that month coincided with the end of a 10-week market correction and proved a great buying opportunity.

The bottom line is that unless you believe that the economic slowdown in China and other emerging markets is going to see their economies hit stall speeds of below 3 to 4 per cent, and earnings in Europe reverse by more than 20 per cent next year, then the risk premium factored into current market pricing in European markets is simply too high. The same is true in the US as the S&P 500 is priced on a forward PE ratio of 16.5, implying an earnings yield three times greater than 10-year Treasury bonds, an attractive valuation for an economy churning out robust growth and one well placed to shrug off the fallout from an emerging market slowdown.

Moreover, if the Federal Reserve pushes back the date of the first interest rate hike - the next meeting of the rate setting FOMC is in mid-September - as I fully anticipate will be the case, then this will undoubtedly ease some of the distress and capital flight from Asian markets. It should also set the stock market up for a fourth quarter rally on both sides of the pond, and beyond.

In the circumstances, I feel this is the time to exploit market weakness, not to fear it, a strategy I intend to take full advantage of in the coming weeks by running my slide rule over the value plays emerging in my small cap hunting ground.

MORE FROM SIMON THOMPSON...

I have published articles on the following companies in August:

Non-Standard Finance: Buy at 107.5p; Software Radio Technology: Buy at 27.5p, target 40p; Character Group: Run profits at 500p; Communisis: Hold at 50p ('Value judgements', 3 Aug 2015)

Fairpoint: Buy at 138p, target 190p; Creston: Run profits at 155p; Sanderson: Buy at 71p, target 80p to 85p; Renew Holdings: Buy at 340p, target 375p ('Break-outs looming', 4 Aug 2015)

Globo: Buy at 42.75p, target 69p; Cambria Automobiles: Run profits ('Short sellers in for shock treatment', 5 Aug 2015)

Cohort: Run profits at 357p, target 375p; Cineworld: Run profits at 530p; Paragon: Buy at 412p ('Acquisitive growth drives re-ratings', 6 Aug 2015)

PROACTIS: Buy at 93p, target 117p ('Procuring growth', 10 Aug 2015)

Town Centre Securities: Buy at 310p, target 350p ('Equity market watch', 11 August 2015)

Equity market strategy ('Equity market watch', 11 August 2015)

KBC Advanced Technologies: Buy at 122p, target 165p; Getech: Buy at 59p, target 80p ('Fuelled for strong growth', 12 August 2015)

Pure Wafer: Run profits at 162p, target 178p; Inland: Run profits at 71.5p, next target 80p; Macau Property Opportunities: Take profits at 189p ('Bumper cash returns', 13 August 2015)

Inspired Capital: Accept cash offer of 21.5p; Record: Buy at 40p; Pittards: Buy at 128p; Netplay TV: Buy at 9.5p ('Bargain shares updates', 17 August 2015)

Equity market strategy ('Stay calm', 25 August 2015)

Capital & Regional: Run profits at 67p; Redde: Run profits at 152.5p; Cineworld: Run profits at 578p; Cohort: Run profits at 375p; H&T: Buy at 195p; Record: Buy at 33.5p; Bioquell: Buy at 137p, target range 170p to 185p (‘Running bumper profits’, 27 August 2015)

■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.95 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'