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Here we go again

Created:

6 July 2009

Written by:

Simon Thompson

The surge in US equity markets from their March lows to their June highs has certainly been mightily impressive, with the S&P 500 bouncing back 42 per cent in this time. However, it is worth noting that the recovery has little to do with earnings surprises to the upside, and more about investors betting that the green shoots of economic recovery will not turn out to be weeds.

You can see that from the trailing earnings multiple on the S&P 500, which has expanded by six points from 17 to 23.3 times (based on underlying operating earnings), while the forward PE ratio has risen from 11.7 at the March lows to 14.5. The disparity between the two ratios indicates the recovery in corporate earnings that investors are optimistically banking on next year.

Déjà vu

If this sounds familiar that's because it is. Cast your mind back to the 2000-2003 bear market and September 2001, in particular, when investors were similarly upbeat about green shoots of an economic recovery. This underpinned a strong rally that eventually sent the S&P 500 up 23 per cent in the following four months alone. By early March 2002, when the rally ended, the trailing operating earnings multiple on the index had widened by five points and the forward PE ratio had expanded by three points.

Interestingly, the sectors that led the charge eight years ago (consumer discretionary, financials, tech stocks) and the laggards (health care, utilities and consumer staples) are eerily similar to the leadership we have been witnessing this time round. Moreover, on both occasions the yield on 10-year US Treasury bonds surged (by 63 per cent basis points between 21 September 2001 and 9 March 2002 and by 93 basis points between 9 March 2009 and 12 June 2009); equity market volatility dropped back steeply (Wall Street's 'gauge of fear', the Vix, fell by over 50 per cent in both periods); credit spreads narrowed and commodity prices rose sharply.

It's also worth remembering that the 2001/2002 stock market rally proved a false dawn. By the time its final bear market low was reached in October 2002, the S&P 500 had dropped a painful 35 per cent from its March highs. The point is that investors had bid up share prices too far during the rally that there was no room for disappointment from both the corporate and economic news flow on which the higher valuations were being justified.

The view from Chicago

Will history repeat itself? To arrive at a view, I looked at the the Chicago Federal National Activity Index (CFNAI:www.chicagofed.org/index.cfm), an index of economic activity and inflationary pressure. It has no fewer than 85 components, whereas the ISM PMI Index (www.ism.ws) only has seven variables and the Conference Board Leading Economic Index has 10 (www.conference-board.org). When the CFNAI drops below -0.7 it indicates recessionary pressures in the economy.

The reading for May this year was -2.3, and the three month moving average of this index was little changed at -2.67, having bottomed out at -3.68 in January 2009 and fallen from -0.47 in January 2008.

So, the CFNAI is sending out a strong message that the broad economy is still deep in recession with the four major categories fitting the National Bureau of Economic Research (www.nber.org/cycles) definition of recession firmly in negative territory in May. Not surprisingly employment was the major drag, with US unemployment rate recently hitting a 26-year high of 9.5 per cent.

It's no better in housing. The negative reading from the housing and consumption category of indicators reflects the fact that there is still 9.6 months' supply of homes up for sale in the resale market and 10.2 months' supply of inventory in the new-build market. So far, there have been only modest improvements in the sales needed to clear the deep overhang. Indeed, monthly sales figures of existing homes are up just 6 per cent since January, while new build sales are just 4 per cent higher.

The production and income category deteriorated further and though the sales orders and inventories categories improved, but these were still in negative territory.

Comparisons

Interestingly, the last three US recessions only ended when the three-month moving average in the CFNAI was way above current levels: -1.22 in 2001, -1.55 in 1991 and -1.38 in 1982. In other words, given that the three month moving average has only managed to pull back 100 basis points in the past five months, it looks increasingly likely that economists pinning hopes on a September end to the US recession are being overly optimistic. That has ramifications for equity market investors, too, who have been betting heavily on an early end to the recession.

Indeed, the savage reaction by the markets to a dire set of US employment figures last Thursday is likely to be a taste of things to come if the economic data and corporate news flow fails to match the heady expectations priced into equity market valuations (Price and Value, 15 June 2009). That looks increasingly likely, given the imbalances and structural problems facing the US economy (A Message from Mr Bond, 2 June 2009).

In the circumstances I can only reiterate my trading advice last week (Going Dow-n, 23 June 2009) to short sell the US equity markets, and the Dow Jones Industrial Average, in particular.