Whatever it is Merrill Lynch’s David Bianco is smoking we’d like some of it…
… because we can’t help feeling things are going to get a whole lot worse before they get any better.
Much like Morgan Stanley’s Graham Secker in fact, who just penned what to our mind is much realistic note on the outlook for the equity market.
(Emphasis throughout ours).
We believe it is increasingly likely that DM economies are now at the end of their debt supercycle and that the need to de-lever going forward will weigh on the growth outlook. Further, the pro-cyclicality of fiscal policy over many years has created a situation where policymakers no longer have the policy tools to drive a sustained economic recovery. The implications of this are poor growth and heightened uncertainty that should in turn lead to a lower multiple for stocks and supports our thesis that the market is likely to overshoot on the downside as we go through this process.
To get an idea of how much the market could undershoot, Secker looks toward the Shiller PE.
Market sentiment and valuation are low in a historical context, but are not yet at extreme levels of bearishness – for example, there is still 10% downside to a single-digit Shiller PE for Europe. Furthermore, equities are unlikely to bottom until we get evidence of fundamental improvement.
Or to put it another way, Secker says the market is currently only discounting weak economic growth and not recession.
If we assume that a forward PE of 10 is a reasonable estimate of fair value through this cycle then it would imply the market is now pricing in our forecast for around 6% decline in EPS. To put this in context, in the previous five recessions the average drop in EPS has been c. 40%. In short, the market is pricing in a very weak growth environment, although it remains some way from pricing in a recession.
In any case Secker doesn’t think the market is going to trough until we see the following.
1) ECB embarking on large-scale QE;
2) A restructuring and re-orientation of fiscal policy to create a sustainable long-term framework as well as investment in real assets and jobs that will enhance growth and productivity in the future;
3) And restructuring of debts for some over-levered entities whether they be countries, banks or households (with a commensurate plan to mitigate further contagion).
Note that Secker doesn’t mention the Fed, QE3 or Operation Twist. And that’s because he doesn’t think they would work. In fact he thinks a move to floor near term interest rates and move into longer-duration bonds could be detrimental (banks and other financial entities traditionally profit from a steep yield curve, don’t you know).
As for QE….
Moving further out the spectrum, if the Fed were to engage in additional QE along the lines of QE1 and QE2 we would again be cautious about any possible positive outcome. The reason for our skepticism is that we believe that the key driver of stocks is growth and not liquidity. As we have illustrated in previous reports, we believe the positive correlation between equity markets and QE programs over the last couple of years is somewhat coincidental and more reflects the fact that lead indicators such as the ISM were troughing around the time of new QE announcements, rather than the impact of QE itself. We are not saying that QE is totally ineffectual, rather that this form of monetary policy only really produces a positive reaction if it coincides with an improvement in underlying demand. In 2009 the demand came from a fiscal boost and a restocking cycle while QE2 coincided with an improvement in the US labour market.
However, it might help in Europe.
If the Fed were to embark on another round of QE in its current form it is unlikely to drive a meaningful rally for US stocks. However, European markets should respond more strongly if the ECB were to go down this route (as long as they do so aggressively) as it would reduce the probability of nasty tail-risk events (even if it doesn’t amount to a structural solution).
Unfortunately he can’t see that happening just yet.
In the long run we are confident that we will get there; however, the shorter-term is likely to remain highly volatile until there is enough ‘pain’ to force the necessary political and social will to achieve these ends.
Until we reach that point we believe investors should remain cautious and we maintain our view to sell into any tactical rallies. The lesson of a bear market is that the majority of investors are never cautious enough on the way down as they are always fearful (or maybe hopeful) of policy response; however, the reality is that truly effective initiatives are rare. Given that analyzing politics is even more uncertain than analyzing stocks, we believe that investors should be wary of trying to identify turning points in advance.
Summer of volatility gives way to a mood of quiet resignation – Tom Stevenson