European equities – trick or treat?

FT Alphaville

In keeping with the bearish mood this Monday morning, we present selected lowlights from the latest Graham Secker note. Morgan Stanley’s European strategist has downgraded equities to “underweight” following the double-digit rally, to reflect the inadequate policy response to the Eurozone debt crisis, weakening economic growth, falling margins and some technical gubbins.

Now, we should make clear, Secker’s not forecasting a big fall in stocks in the near term. Rather his downgrade reflects the fact that the overall macro environment in Europe is becoming tougher, equities are not particularly cheap and no big policy breakthrough appears to be imminent. (Indeed, one of the things that would make Secker turn positive on equities would be QE from the ECB).

But he still thinks investors should be looking to preserve wealth by selling into the recent rally.

October’s rally unlikely to be sustainable
To use seasonal parlance, we believe the market’s strong bounce in October will prove to be more of a trick than a treat. While the market may hope this is the start of a longer-lasting rally into year-end, we suspect this is just a traditional counter-trend rally in an ongoing bear market. We believe investors should look to use any residual strength in stocks and sectors as an opportunity to construct an even safer and more secure portfolio – at this time the prime goal of investors should be wealth preservation rather than wealth generation. In this regard, we are making some changes to our European model portfolio, increasing our underweight in Financials, and putting more funds into defensives.

And here in further detail is why.

Four reasons to downgrade European equities Post a double-digit rally from the lows, we take the opportunity to downgrade European equities to underweight to reflect the following four points.

#1 – Policy response not yet sufficient – We do not believe that the ongoing policy response is yet at a level where it can stabilize equity markets. QE from the ECB would be the key positive game changer for stocks in our opinion.

#2 – Economic growth deteriorating – Key economic indicators suggest that the Euro-zone economy is slowing with the prospect of additional austerity and bank deleveraging to come. We doubt the recent improvement in US newsflow is sustainable into 2012.

#3 – Corporate margins are falling – In addition to weak economic growth, corporate profits are coming under increasing pressure from deteriorating margins.

#4 – Market timing indicators now less constructive – We have seen a meaningful rise in our key market timing indicators and, although not particularly high, they are no longer in ‘buy’ territory.

There’s one other point from Secker’s note that’s worth picking up on: the idea that European equities are cheap. They’re not.

If the market trades on a single digit Shiller PE, as Secker thinks it will at some point in this secular bear market, there’s 20 per cent downside from here.

And the market’s 4 per cent dividend yield is not all it seems.

Relative to government bond yields, we accept that the equity market’s dividend yield of over 4% is very attractive. While such a situation is rare in the context of the last 50 years, prior to that it was commonplace as illustrated in Exhibit 19. In reality, this spread is a reflection of investors’ appetite for risk, and it is possible that risk aversion can stay higher going forward due to concerns over the structural outlook for DM economic growth and increasing geopolitical risk/social unrest.

Note that the dividend yield on stocks also has to compete with a decent yield from corporate bonds that may be more appealing than stocks in a low growth environment (see below Exhibit 20). Note also that an underweight position in stocks does not mean that we like government bonds either, and we believe that these latter assets are likely to produce negative real returns for investors for the foreseeable future as policymakers engage in financial repression. At this time, our preferred asset class would be corporate bonds, while we also like the optionality of cash as it would allow us to step back into the equity market if prices fall significantly in the coming months.

Exhibit 19 and 20.

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