European Credit Crisis ? – A Global Problem !

To my valued clients and friends,

October 31, 2011

Equity Markets

This summer has been the worst downturn since the downturn of 2008 of the Asset Backed Commercial paper (ABCP) crisis. The three main causes of uncertainty globally and declines in equity markets have been in order of occurrence: 1.) Arab Spring 2.) Fear of an economic slowdown in China, Europe and US. 3.) The European credit crisis with Greece, Italy and Spain presenting the greatest risks. Even though the Arab Spring and the slowdown fears have had some impact the main cause of the recent decline was the European credit crisis. Peak to trough the TSX had lost most of the major indices, down 24.3% (Fig. 1) and even the Dow Jones Industrial Average (Fig. 2) that lost the least still was down 19.2% from peak to trough, the S&P 500 lost 21.6% (Fig.2) and the NASDAQ 20.4% from top to bottom.

 Fig 1. – TSX

The European debt crisis has had as much impact on equity markets this year as the ABCP crisis several years ago. The major difference however is that the European debt crisis has not had much impact on North American income statements and balance sheets whereas the ABCP crisis had ruined banks globally. In fact North American earnings, despite the debt crisis in Europe, have continued to do well. This has brought earnings multiples to bargain levels recently. Equity markets have since recovered somewhat with optimism about a resolution to Europe’s problems emerging after Europe has indicated that a deal has been reached with bond holders of Greek bonds taking a 50% haircut. Although a deal has been reached in principal, details will still have to be worked out and delays could still cause some havoc for equity markets and the deal does not mean that austerity measures are not needed anymore. Generally equity markets are still cheap compared to their long term averages.

I have compiled a comparison of P/E ratios for the major North American equity indices below.

Table 1 Oct 31, 2011



31, 2011









The best indication of overall equity valuations is the S&P 500 index as it is the broadest index. The S&P 500 index has traded as high as 44 times earnings and has had a long term average since 1880 of 16.4. This would indicate that the S&P still trades at almost a 20% discount to its long term average. Even without the extreme outliers the median P/E ratio for the S&P 500 is 15.6 where the current level still represents a 15% discount. (Table 2 below). The P/E ratio for Dow Jones Industrial Average has been as low as 10 and as high as 28 since 1929.

Table 2 

S&P 500 P/E Ratios
Current 13.2
High 44.2 (Dec 1999)
Low 4.8 (Dec 1920)
Mean (Average) 16.4
Median (Average without outliers) 15.6

Third quarter earnings have grown 14.3% “adjusted” and 20% “as reported” over a year ago levels and 70.4% of companies have outpaced expectations as of October 28th whereas only 19.8% have fallen short of expectations. Continued growth in corporate earnings will stimulate employment.

Fig.2 – Dow Jones Industrial Average

The Economy, Inflation, the Canadian dollar and Crude Oil.

Inflation has crept up over the past year with the most recent readings at 3.2% in Canada and 3.9% in the United States due to higher energy and food prices. Although there are signs of inflation and improving fundamentals the Federal Reserve in the US is still taking a very cautious approach to increases in interest rates as unemployment is still stubbornly high at 9.1% compared to an average of 5.7% since 1948 in the US.

Even though Canadian unemployment levels are significantly better with its latest unemployment rate at 7.1% compared to an 8.5% average since 1976 the Bank of Canada is unlikely to take a much more aggressive approach to the US to avoid a rise in the Canadian dollar. (A comparative increase of interest rates in one country over another will cause its currency to rise as money will flow to the country with the increasing interest rate).

Central banks mostly control short term interest rates to control inflation with a few exceptions such as “Operation Twist” recently. Longer term bonds have levelled out and the bond bull market may be coming to an end at some point now. Softness of prices of Long term bonds are often the initial indicator of increasing interest rates. (Prices of bonds are inversely related to bond yields – softness in bond prices indicates an increase in bond yields and long term interest rates).
The Canadian dollar, in the absence of diverging central bank policies, will continue to be highly correlated to oil prices. Although resources prices have shown significant weakness over the past year, improvements in equity markets will most likely slow down its decline in the short term and will also offer some support or strength to the Canadian dollar. With conflicts in oil producing countries declining and the reduced fear of supply constraints in the oil market, oil prices will likely soften more over the long term. In perspective by 1998 oil prices declined to about $12 per barrel from a high of about $30 and a brief spike to $40 per barrel in the early 90’s during Iraq’s invasion of Kuwait. Since then oil prices sky rocketed to over $140 per barrel in 2008. Subsequently oil prices collapsed to a low below $40 per barrel. Over the past two years oil prices stabilized and are now fluctuating between $75 and $95 per barrel, with a short rally over $110 early this year.


I expect:
• Strength in equity markets with some volatility in the short term
• Higher inflation rates
• Weakening long term bond prices (increased bond yields)
• Stabilizing to weaker oil prices over the long term
• Longer term weakening of Canadian Dollar
• Improving economics and unemployment rates

Should you wish to discuss the thoughts above further please contact me at (416) 572-2265 or e-mail me at Albrecht Weller

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