David Rosenberg – former Chief economist at Merril Lynch – September 23 2009
The banker J.P. Morgan was fond of saying: “I never buy at lows, I never sell at the highs, I play the middle 60 per cent.” Well, from our lens, we are well past that middle 60 per cent point of this bear market rally.
At the lows in the equity market in March, the S&P 500 was de facto pricing in a 2.5 per cent decline in real gross domestic product and $50 of operating earnings for the year. Guess what? Far from being grossly undervalued (although some stocks were – especially financials, priced for bankruptcy), the market at those lows was fairly priced on a price-to-book and price-to-earnings basis.
Usually at bear market troughs, the S&P 500 goes to silly cheap levels. It did not this time round and, six months and 60 per cent later, there is yet again, in 2007 style, tremendous risk in this market. Never before has the stock market surged this far, this fast, between the time of the low and the time the recession (supposedly) ended. What is “normal” is that the rally ahead of the recovery is 20 per cent. This market is now trading as if we were in the second half of a recovery phase, yet it has not even been fully ascertained the downturn is over.
Remember, Mr Dow and Mrs Jones are not always rational beings. At the stock market highs of October 2007, equity valuation was embedding a 5.0-5.5 per cent GDP growth profile. What did we end up with? Try flat, on average, over the subsequent four quarters. Fast-forward to today and the S&P 500 is priced for 4 per cent real economic growth in the coming year. It is far from impossible to see that, but the odds are low – less than 20 per cent in my view.
An unprecedented eight-point price/earnings multiple expansion during a six-month faith-based rally has left the market at its most expensive (26 times operating profit, 180 times reported profit) in seven years. On a reported basis, this market is nearly four times overvalued, as it was during the tech bubble! Indeed, when we look at the history books to see what happens after the P/E multiple on trailing earnings pierces the 25 times threshold, the average total return a year out is -0.3 per cent and the median is -6.2 per cent. The total return is negative a year later 60 per cent of the time, so when we say that there is too much growth and too much risk embedded in the equity market right now, we like to think that we have history on our side.
We have been willing to express a cyclical view more through the fixed-income market, namely our corporate bond and premium income strategies. Based on our research, Baa corporate bonds were pricing GDP contraction of 10 per cent at the widest spread levels, not 2.5 per cent as the stock market was discounting at the lows.
Now that is silly-cheap and, while the low-hanging fruit has been picked in the credit space, the corporate bond market is now priced for 2 per cent real GDP growth, not 4 per cent. In other words, there is less risk in credit than there is in equities, even after corporate spreads have been sliced in half from their depression-era levels. By way of comparison, we discovered that if the stock market had priced in the true Armageddon 10 per cent contraction trajectory the credit market had been discounting at its worst levels, the S&P 500 would have bottomed around the 315 mark. This puts the 666 diabolical low, horrific as it appeared, into proper perspective.
Flipping the analysis around, what if the stock market were pricing in the same 2 per cent growth rate the corporate bond market is discounting? Answer: 842 on the S&P 500. So, if you’re asking us if we think we will see a 20 per cent correction in equities, the answer is Yes. Sure, there could be another 100 points left in the S&P 500 from here to the upside in the near term, but it is seldom wise to chase an overvalued market to the top unless you are gifted enough to know when to call it quits.
The next question, naturally, is where Baa spreads should be trading if they were to align with the 4 per cent real GDP growth implicit in equity prices. The answer is: 200bps spreads over Treasuries, or about 100bps tighter than they are today.
To reiterate, the equity market is overvalued and carries too much risk right now.