Among the many adages that stock market followers repeatedly come back to is that “stock markets have predicted 11 of the last 5 recessions.”  The implication of this glib phrase is that the stock market has traditionally filled a role as an exceptional lead indicator of economic activity as it has fallen in the year preceding pretty much every recession over the last 80 years.  But it has also fallen on numerous occasions seeing a subsequent recession, thereby giving a false signal.  While the final outcome will not be known for some time, we have to raise the probability that investors are panicking due to the demoralizing headline news and dearth of real economic or earnings data in the past few weeks and just selling because markets are falling and they’re worried rather than because we are actually heading into another global recession less than 2 ½ years after coming out of the prior recession.   For now, however, the bears are in control of the financial markets and that was readily apparent in the past week with the S&P 500 and TSX stock indices each falling 6.5%, on top of the losses they had already seen over the last few months.  That puts the Canadian market 19% below its April high and the US 17% below that same peak, both on the verge of the generally-accepted ‘bear market status’ of a 20% decline in prices.  The global stock market is already in a bear market due to the exceptional weakness in European markets.  The MSCI World Index has fallen 21.5% from its April high.  In terms of sectoral weakness, the resource groups have lead on the downside in much the same way they lead to the upside during 2009-10.   The TSX Energy index is down 33% from its high earlier this year while the TSX Mining Index is down a whopping 45% in the past five months as investors move to areas views as ‘safe havens’ such as high yield stocks, gold and bonds.

The most recent push to the downside came after the release of US Federal Reserve Board comments from their meeting on Sept. 21st that said that there are “significant downside risks to the economic outlook, including strains in global financial markets”.  The ‘significant downside’ comment was new and panicked investors further, leading to a large scale liquidation of financial assets over the rest of the week, particularly the commodity-related assets that would be most at risk in a global recession.   The technical condition of the stock market is still to the downside and the momentum is exceptionally negative but the key U.S. stock market averages have not broken through the support levels seen at the August 8th lows, even though the Canadian market did close below those levels.  Our view is that the economic and corporate earnings data, though slower than earlier this year, are nowhere near the levels being priced into stocks and commodities currently.  While sovereign risks in Europe have definitely increased, there have yet to be any defaults and the majority of the financial institutions are still comfortably above the levels required in any stress-testing scenarios.  While stock and commodity markets have effectively ‘priced-in’ a moderate global recession, the economic data are nowhere near as dire.  Recent corporate earnings guidance, global growth indicators and commodity supply-demand balances all point to a slowdown in growth over the past two quarters but no recession.  Financial markets are either correctly anticipating a severe, near-term slowdown in growth or else they are in the process of creating another tremendous buying opportunity, similar to the early 2009 period.  Our view continues to be that it is the latter.

Sentiment is one area where the bears have taken clear control, both on the markets and the economy.  A CNBC viewer poll taken on Friday (Sept. 23rd) found 63% of respondents expecting an ‘economic depression’ beginning in the next year!  The relentless bad news on headlines and the constant replay of investment opinions from the most pessimistic prognosticators has succeeded in demoralizing investors and even impacting consumer and business sentiment surveys.  Our strategy in this environment of panic is to focus on the actual data and the investment metrics that we have used for the last 30 years to position the portfolios we manage for longer-term growth.  For us, this strongly suggests an overweight position in stocks relative to bonds and cash with a focus on those companies that benefit from global expansion that will be lead by the emerging economies, which now make up over 30% of the global economy.  Technology companies are positioned to benefit from global productivity growth and are at the lowest valuations ever seen for that sector.  Energy, industrial and basic materials companies are generating substantial cash flows and starting to use these cash positions to acquire and expand.

Investors are too focused on the negative data and headlines and are missing many positive actions that suggest that the economic situation will not get nearly as bad as most expect and that stock prices have already made an adjustment downward for these lowered expectations.  Some of the positives that came out in the past week that have effectively been ignored include:

  1. The announcement that United Technologies will pay over US$16.5 billion in cash to acquire Goodrich Corp at a price 47% above its prior day’s close.  While not immune from mistakes, it’s hard to see large corporations doing such deals if they were worried about deteriorating economic conditions.  Many such deals have occurred in a variety of industries over the past few months, including Google’s US$12 billion purchase of Motorola Mobility.
  2. China is successfully engineering a ‘soft landing’ on their economy as they unwind inflationary pressures (which are already on the decline) while slowing growth to a more moderate level.  While the negative focus has been on the ISM surveys bordering on the 50 level, the line between expansion and contraction, we heard very little about the most recent ‘flash business survey’ which rose to 59.3 in September from 55.4 in August, indicating a return to higher growth for the balance of 2011.
  3. The recent commentary and earnings guidance from global corporations that have always been great lead indicators of future financial and economic activity (i.e. UPS, Fedex, BHP, Dupont, Caterpillar, tech companies) remain positive, pointing to continued expansion in emerging economies, northern Europe and the US.
  4. Most of the very bearish economic readings came from ‘sentiment related’ indicators (i.e. data from surveys of individual or businesses as opposed to ‘harder’ data on items like retail sales or industrial production).  These sentiment indicators do tend to be somewhat more volatile since they are influenced by news events and public opinions, as opposed to just the basic data from other indicators.
  5. Stock valuations of cyclical companies is already reflecting dire economic conditions.  Cliffs Inc., a producer of iron ore, has fallen over 40% in the past two months to under $60, even though earnings are expected to hit over $13 per share this year and over $17 next year.  The stock is effectively reflecting iron ore prices of US$110 per tonne when the price of the commodity is firm at US$175 currently.  Auto stocks GM and Ford are trading at under 5 times current earnings despite the fact that auto production is still rising and earnings are expected to show strong growth this year and next.

There just seems to be a trend lately to focus only on the negative aspect on any piece of news.  Wednesday this past week was a classic example of this;  coal stocks fell by over 7% on average that day after both Walter Energy and Alpha Coal announced that they would not meet earnings guidance for the quarter.  The reason was not a cancellation of orders or economic weakness though, but because they each had mine production problems that would limit how much they could produce on the quarter.  In theory, this restricted supply should lead to higher coal prices, not lower ones, so it seems fairly illogical that all coal stocks dropped sharply on this news.  A similar story in the oil patch where the IEA (International Energy Agency) dropped their global demand outlook for next year by 200k barrels per day (in a market of over 86 million barrels per day).  However, in the same release, they also reduced non-OPEC supply by an identical 200k barrels per day.  The net effect of identical drops in both supply and demand should be nil, in theory, but investors treated it as a reason for heavy selling in the oil stocks.

While the sentiment of investors is at rock bottom levels, the classic economic signs of recession just aren’t as apparent.  Pretty well every global recession since World War II has been preceded by an inverted yield curve and a year-over-decline in the leading indicators.  Right now, neither of those conditions are even close to taking shape.  Meanwhile, global stock valuations and sentiment indicators have fallen back to the 25-year low levels seen in early 2009 despite the fact that interest rates have fallen to levels not seen since the 1940s (which, in theory, should lend support to stock valuations).  The fact that the ratings agencies downgraded US debt in the summer and European banks in the past week has also increased investor fears.  But ratings agencies have typically been ‘lagging indicators’ of the actual changes in the market.  They wait until data is confirmed which is generally long after the stock markets have taken the same scenarios into their outlook.  Panic is creating tremendous buying opportunities in many strong global companies and our strategy is to continue to add to these names and increase equity exposure within the portfolio even though the short-term volatility of the markets will remain.

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.

Yield Curve Not Predicting Recession

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.

Canadian Stocks 25% Below Historical Fair Value

The risk is that we head into recession and earnings fall but, for now, consensus 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.

Another measure we like to look at is the relative attractive of stocks versus bonds.  The well-known ‘Fed Model’ compares the earnings yield on stocks (i.e. the yield that stocks would have if they paid out 100% of their earnings to shareholders) to the yield on the 10-year government bond.  The chart below shows the Fed Model since 1980.  For two decades the two measures moved almost completely in line with one another, both when interest rates were high (like in the early 1980s) or low (like in the 1990s).  They got out of line in the 1998-2001 period as earnings yields fell. This was the period of the technology bubble which was, in retrospect, a good time to lighten up on stocks relative to bonds.  So the model was working accurately during that period as well.  However, since that point, as can be seen below, the two lines have diverged with stock yields rising and bond yields falling.  This has continued to where we are now with the spread between the two yield lines at record levels of over 750 basis points (bond yield at 1.8% and earnings yield on stocks at 9.4%).

Stocks at Biggest Discount to Bonds on Record

There are basically only 3 ways to resolve this situation in the longer term.  Either one of the following has to occur to bring these two measures back in line.

  1. Interest rates have to rise sharply from current levels (something almost no one expects in the current environment)
  2. Corporate earnings have to basically collapse (we’re not talking about a slowdown in earnings growth or even a slight decline; we would have to see a 30-40% decline in earnings)
  3. Stocks are under-valued and have to rise substantially.

Alternatively, we could see a combination of all three of the above.  This is probably the most likely final scenario; earnings growth slows down or even goes negative for a brief period of time but the economy does not go into recession, interest rates start to firm up as economic growth resumes and the stock market rallies.  The world has not changed so much in the past few years that we should be throwing out models like this that have worked for decades.  The volatility of financial markets has certainly gone up over the past few years, more information is passed on in real time thanks to the advent of more communications technology and money flows have become more concentrated with the plethora of larger hedge funds that also tend to be much more active investors.  All of this has contributed to larger and more immediate moves in financial markets and under-mined the confidence of the average investor in the system.  But, in the end, the simple laws of supply and demand and relative valuations will always win out.  This means that rationality will return and valuations will move back to historical norms.  This has been the one constant over the long term in financial markets and we don’t believe that it is going to change.

For now, however, investors have a huge degree of wariness about the outlook for both the economy and the stock market.  Some of this opinion is reflected in the chart below, which is the Investors’ Intelligence Bull/Bear Ratio.  This measures the bullish versus bearish opinions of a large sample of market letters and strategy reports put out by various brokerage firms and independent analysts.  Their cumulative track record over time has been quite poor as high levels of bullishness in these letters has been associated with market tops while bearish periods have given rise to market bottoms.  The Bull/Bear Ratio (charted over the last 3 years below) has therefore started to become recognized as a very good ‘contrarian indicator’ (i.e. going in the opposite direction to the recommendations has resulted in better market timing).  When the ratio rose above 2.0 times in January and April of 2010 and again in April of this year, we have seen stock prices lower over the following month.  Alternatively, the ratio actually went negative (i.e. more bearish than bullish opinion) in early 2009 and then again in the summer of 2010 (both period coincided with lows in the stock market followed by subsequent sharp rallies).  Interestingly, the ratio has been falling since the April peak and went negative again in September.

Bearish Sentiment on Stocks Back to Market Bottom Levels

On top of the negative sentiment from investment advisory services, the actual behavior of investors has also gone negative with short positions in the S&P500 index (i.e. bets that the market will fall) increasing sharply over the past two months to the highest level in four years.  The history of this indicator as a forecaster of stock prices is not really that good since it is relatively short, but the notion that you want to be somewhat contrarian (i.e. not moving with the crowd) would certainly point you in the direction of being more bullish than bearish, since it seems that many large investors have placed themselves in a position to benefit from a market decline.

Speculative S&P Short Positions Highest in 4 Years

The stock market forecasting 11 of the past 6 recessions is certainly one of the old adages that investors have used for a long time but so is the phrase that ‘stocks will move in the direction that causes the most pain to the greatest number of investors.’  If our sentiment indicators referred to above are at all accurate, then the direction of most pain for investors would be a rise in prices!

How does the global economy escape a meltdown?  When talking to investors and advisors this seems to be the biggest concern.  With the problems in Europe, the U.S. debt crisis and even some fears about a slowdown in some emerging market economies, where does the stimulus to grow the economy out of this hole come from?  Investors seem to be looking for some ‘magic bullet’, a policy statement or change that will quickly bring these changes about.  But with interest rates already at all-time lows and government finances so strained, maybe the authorities are out of ammunition to initiate any stimulus.

Our view continues to be that many investors are, first of all, ignoring the secular growth story going on in the emerging economies, which now make up a significant 30% of the global economy.  They are embracing capitalism and expanding industrial production at the greatest rate we have seen since North America and Europe after the end of the second World War.  Governments and consumers in those economies are also net savers, meaning that they have the ability to supply capital to support their continued growth.  Also, the US consumer is now in much better shape than they were during the financial crisis.  Three years of debt de-levering is starting to work and personal balance sheets are starting to come down to more normal levels.  Meanwhile, the business sector is in better financial shape than it has ever been.  US companies are sitting on a combined total of over US$2 trillion in net cash that is slowly being deployed back into the most attractive economic opportunities, including expansion, acquisitions, capital spending, stock buybacks, dividend increases and even increasing payrolls.  The problems of some financially-impaired European economies on their own will not be enough to bring down the global economy.  In over 30 years of meeting companies, I have yet to hear of one saying that any of their growth issues were due to slowdowns in Greece, Italy, Spain or Portugal!  We continue to believe that stock investments made today will yield substantial returns over the next few years, particularly compared to the expected returns on bonds or cash over the same period.  There are just no guarantees that things don’t get worse in the short-term since it’s hard to quantify levels of panic.  One more final old adage is that “no one rings a bell” at market bottoms.  But the ringer might be muted and it’s probably vibrating wildly right now!