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What if we’re wrong? Maybe the stock market is just fulfilling its typical role as a good lead indicator of future economic activity and we are indeed heading into an economic downturn of unknown proportion. That could certainly be the case but, in many ways, the stock market has already reflected a moderate recession with the declines already seen. Anything less severe than that should actually lead to stronger stock prices or at least some stabilization around current levels. Further stock losses from these levels would only occur if the economy began to shrink and earnings growth went significantly negative. With global economic growth still set to come in around 4% this year and profit growth around 15%, we are a long way off the economic scenario that would create much further downside for stock prices.
As indicated earlier, none of the classic recession indicators are flashing warning signs right now. The diagram below charts the Yield Curve in the US over time (difference between the yields of 10-year versus 2-year government bonds). Prior to each recession we’ve seen the yield curve ‘invert’ (2-year interest rates rise above 10-year rates). We can see that the spread, though having narrowed, is still positive by almost 200 basis points.
While the economic data don’t show the classic recession signs, stock valuations have sunk well below fair value. The chart below is the UBS Canadian stock market model (which we’ve referred to in many prior comments) and it shows the ‘historical fair value’ of the TSX composite index (grey shaded area) versus the actual level of the TSX composite index (blue line). The model has had a high degree of accuracy and the stock market has traded well above this range only once in the past 25 years (during the tech bubble) and then dropped well below the range during the bear market in 2008/09. It rallied since then to the bottom end of that range but has since collapsed and is now more than 25% below the mid-point of that fair value range (and over 20% below the low end of the range). More importantly, as long as the economy keeps expanding and earnings keep growing, the fair value range will continue to increase. For longer-term investors this is a very bullish time to be buying stocks, even though markets could still fall further in the short-term.
The risk is that we head into recession and earnings fall but, for now, consensus is TSX earnings are still expected to rise 25% this year, and 16% in 2012. The 2011 sector earnings growth profile is still led by materials (70% growth) and energy (33% growth), with the other 8 non-resource sectors expected to rise by just under 10%. This is important since those two resource sectors have been the largest contributors to the overall weakness in the market this year and yet their earnings are still in line to show the best growth. The TSX is now trading about 11.2x the 12-month consensus forward earnings estimate. In other words, stock prices are discounting earnings that are about 23% lower than current levels given that 14.5x is the average multiple for the market, both from 2004-08 and over the last 25 years.