I spoke with John Rovansek recently about his opinions on the current investment climate in the US. Here are some of his comments.
On Wednesday, September 7, Mark Carney, the governor of the Bank of Canada, decided to hold rates steady at 1%, declaring the need for rate hikes has “diminished.” In his speech he said, “in light of slowing global economic momentum and heightened financial uncertainty, the need to withdraw monetary policy stimulus has diminished.” He cited a deeper US recession and shallower recovery as one of the reasons for the decision.
Over the past few months, I have been laying out a case for considering US and global equities for your portfolios, as part of a strategy to build positions in an asset class that has been somewhat out of favour. With this in mind, along with Mr. Carney’s interest rate decision and commentary, it made me think about corporate earnings, particularly in the USA, P/E ratios and what could impact future earnings. I asked myself this question: Are equities/stocks still cheap? The answer: That depends if you believe the numbers.
For particular stocks, the numbers look good, but for the market as a whole, it’s not so clear. Wall Street strategists have provided all kinds of models and forecasts. The crux of the mainstream bullish argument is that stocks are inexpensive based on standard measures such as price-earnings (P/E) ratios as well as the equity-risk premium. Both measures depend on corporate profit forecasts, which are open to uncertainty. As we know, the problem with forecasts is that they are about the future, and the future is unknown.
A recent report from Societe Generale’s lead global strategist, Albert Edwards, highlighted several key issues. In his report, Mr. Edwards pointed out how corporate profits were terrific in 2010, but have become less so in 2011. Labour costs are surging, which is slashing margins. Mr. Edwards thinks we are at a “tipping point” at which companies can no longer pass cost increases to a low-demand world. While this may be true, we have seen corporations respond to higher expenses by trimming all types of costs, including labour. In the US, an example of this effect and reported in late August, is zero jobs growth. Mr. Edwards also points out that the pace of unit-labour costs is a key driver of inflation and coupled with deteriorating trends in productivity suggests that earnings recovery, based largely on profit-margin expansion instead of top-line growth, is coming to an end.
Back to my question: are stocks cheap? The S&P 500 trades at approximately 13 times consensus estimate of $90 earnings per share and just 11.5 times the $102 forecast for 2012. The equity-risk premium, calculated by comparing stocks earnings yield (the inverse of the P/E) to the 10-year Treasury yield (assumed to be the risk free long term interest rate) indicates that equity asset class prospective returns should vastly exceed those of government bonds. Some stocks already sell at extremely low P/Es (10 or less), despite massive earnings growth over the past 10 years. What has this left? A group of large, global blue chip companies with rock-solid balance sheets, high dividend yields and significant cash generation potential to expand payouts selling at low valuations. An opportunity, in my opinion, worth exploring, particularly if you believe the numbers.
Photo credit: “Sale Sticker (Vector)” by Vectorportal on Flickr