But the big worry for markets continues to be the European sovereign debt issues.  Our view all along has been that this issue represents more ‘headline’ than ‘real’ risk in terms of impact on the global economy.  European growth, particularly in the southern regions, will clearly be hurt and this area may end up going back into recession.  Also, the European banking sector is at risk in much the same way the U.S. banking sector was after the housing crisis.  They will need more capital and growth will be impeded for a period of time.  But beyond that we don’t see a major impact to global growth.  First of all, the total European debt situation is not nearly as bad as the headlines would have us believe.  Euro-Zone government debt as a percentage of GDP (total output) is currently around 85%.  This compares very favourably to the U.S. where that same ratio is above 120% and rising and is far less than Japan, where the ratio is around 170%! (Basically Japan’s sovereign debt is larger than that of the entire Euro-zone put together and yet its economy is only about half the size).  So, in the context of the financial risk to the entire Euro-zone, the numbers simply don’t support the hype.

But investors have been selling stocks aggressively for most of 2011 as their confidence has been shattered by global events this year.  What has probably hurt investor sentiment to a larger degree than most people recognize is the simple fact that the memories of the financial market collapse and subsequent recession in 2008 is still very fresh in investors’ memories, with any downturns making them fear we could be heading back into a similar situation.  But this is not 2008!  Then, global commerce was collapsing, presaging a 10.7% drop in the volume of world trade in 2009, which was the sharpest annual contraction since the 1930s.  Even China was negatively impacted as export performance swung from 26% annual growth in July 2008 to a 27% contraction by February 2009.  Sequential GDP growth slowed to a low single-digit pace, which is a virtual standstill by Chinese standards.  More than 20 million migrant workers reportedly lost their jobs in export-led Guangdong province.  By late 2008, China was in the throes of the functional equivalent of a full-blown recession.

In 2011, interest rates have been increased on 5 occasions in China and bank reserve requirements have been tightened in order to control inflation, which increased to a 6.5% annual rate in July on rising food prices.  But that appears to have been a peak in their inflation rate, which fell slightly to 6.3% in August as food prices have started to moderate.  Economic growth has slowed to a 9.1% annual rate from almost 12% at the beginning of 2010, but this seems to be the ‘soft landing’ that Chinese authorities were looking to achieve.  Even if growth slows further, it should still remain above 8%, high enough to sustain the continued global economic expansion.

So with the economic data less negative, the focus shifts to the valuation of stocks, which continue to hover near record low levels.  Either earnings or about to collapse or stocks are cheaper than they have been in decades (outside of the late 2008 – early 2009 period).  The chart below shows the historical forward earnings multiple of the Canadian market.  Granted, since it is a ‘forward’ number it does include some degree of forecasting, but the valuations of the market on those forward earnings, at 11.8 times, is well below the historical level of 14.4 times.  Moreover, earnings multiples tend to expand when interest rates are lower so today’s record low level of interest rates should, in theory, sustain an ‘above average’ multiple of earnings.

Canadian Stock Valuations Flirting with Record Low Levels

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