Doom and Gloom in equities and the economy or just nervousness ?

October 18, 2012

Doom and Gloom in equities and the economy or just nervousness ?

Over the past few weeks the media portrayed Doom and Gloom about the US economy and its growth prospects. It is September and October, and this year is the 25th anniversary of “Black Monday of 1987”. Several media portals and forecasters predict a cataclysmic outlook for equity markets. In my opinion – NOT SO – I feel there is little risk of a significant decline in equity markets in Canada and the over the foreseeable future. As of October 11th equity markets have rebounded 103.7% for the Dow Jones, 61.7%% for the TSX and 111.8% and 140.6% for the S&P500 and NASDAQ respectively from the lows made in March of 2009. I had taken a “temperature reading” of equity markets back in January 2011 of the equity market recovery at that time. Figure 1 shows equity return up until December 31, 2010.

Fig. 1

 

Since December 2010 US equity indices have, with significant volatility, continued to move higher however not dramatically; although earnings growth has been strong and has outpaced expectations in many cases during this period. As of September 28, 2012 the Dow Jones has added 7.4%, the S&P500 and NASAQ have added 14.5% and 17.5% respectively, however the TSX index has lost 8.4% since December of 2010. Canadian equities have suffered from a slowing resource demand globally that put pressure on the Oil and Gas and Mining sector. In September and October equity markets concerns re-emerge and I feel it is of value at this point in time to re-ensure my clients and friends about US and Canadian Equity markets and the respective economic fundamentals.

Fig. 2

Although many forecasters paint doom and gloom interestingly many economic and capital market indicators point to a much better future. Both corporate and private America has deleveraged although US government debt still has not been reduced. Corporations have significant cash balances on their balance sheets and consumer debt as a percentage to income is significantly lower today than it was 5 years ago. The US housing market has “turned the corner”, as Jamie Diamond of JP Morgan put it, and US consumer confidence is the highest it has been in 5 years. A strengthening housing market has also resulted in a recent 50% increase in mortgages that JP Morgan and Wells Fargo issued, although some of the mortgages are refinancings. An increase of this magnitude indicates that consumers are able to obtain refinancing and are on much better financial footing than they were several years ago. As the US real estate market will improve, so will construction and personal balance sheets. An improvement in the construction industry will lend additional support to the US employment situation and an improvement in personal balance sheets will in turn allow increased consumer spending.
LinkedIn, the professional social networking site, recently disclosed that it has 3.5 million unfilled jobs on in its system. This represents 2.3% of the US labor force. This is only the number of unfilled jobs in the professional sector as LinkedIn members are generally not from the industrial or trades sector. Although the reason for such a high number of unfilled jobs is skill mismatch, in overall it still shows significant labor demand in the US economy.

Weakness and sluggishness of Canadian equities over the summer was caused by the Euro zone crisis and an apparent Chinese slowdown. Canada’s economy is primarily driven by the resource sector, which was impacted by overseas slowdown, whereas US growth is driven by the US consumer which has resulted in a much better year for US earnings and returns.

I have illustrated the recovery, return and valuation (P/E Ratio) statistics of Canadian equity markets in Figure 1 & 2 above. Canadian equity markets, due to its exposure directly or indirectly to the resource and oil and gas sectors have struggled this year. Not only resource equity depend on strong commodities however also the supply industry to these sectors got impacted. The US performed significantly better than Canada. The Dow Jones Industrial Average returned 7.4% plus dividends since

January 2011, significantly stronger then the TSX in Canada. Even though the TSX has declined by 8.4% and the Dow Jones has advanced by 7.4% over the past 18 months, the Dow Jones still offers better value than the TSX with a price/earnings ratio of 14.7 versus 17.9 for the TSX.

The media recently increasingly portrays Doom and Gloom of the US economy and equity markets. MarketWatch, a famous investment Internet portal, had several articles and interviews with hedge fund and money managers that have forecasted devastating outlooks for equities. In my opinion there is very little evidence of risk of a significant decline in equities or the economy in the next 6 months or year. I believe that if the US economy continues the momentum that the economy has now started I foresee significant greater consumer demand and economic activity in the US. This should continue to feed earnings going forward.

Some forecasters have painted a very gloomy picture and have even indicated a risk of another “Black Monday” as we had experience in October 19, 1987. In order to offer a perspective I have compared the current equity valuation versus the summer and fall of 1987. The S&P 500 currently has a Price /Earnings ratio of 16.6 versus over 22 in August 1987, two months before the largest crash since the great depression. This is 25% less than the Price / Earnings ratio at the peak of 1987.

Housing starts in the US have increased 15% last month seasonally adjusted. Although this is still 60% below the January 2006 peak, the housing market has turned around and may actually rebound significantly faster than many forecasters expect based on the increase in mortgages issued that some banks show. The 15% increase is the quickest pace since 2008. In my opinion, the expanding housing market will increase employment in the construction as well supply industries that support construction and will add significantly to economic growth in the US over the next several years.

Even though fear exists over Europe and China, the European factory output offered an upward surprise in August and China still grew at 7.2% annual rate in the per last quarter. A significant contributor to Chinese slowdown was reduced demand by Europe. The Chinese slowdown should have much less impact in North America. Although the European crisis has not been resolved yet, however in my opinion the resolution to the problems are well addressed, in spite that the economic situation in several countries is in dire times with unemployment rates reaching 25% in Greece and Spain, and 15% unemployment rate in Portugal. These economies of these three countries, that have the biggest economic problems, however only present less than 20% of the Euro zone and had in aggregate reduced output of only 2% over the past year as measured by GDP. This should have very little actual impact on the North American economy. Although Chinese growth has fallen from the 10% range over the past decade to an expected 7.6 to7.8% growth this year, the Chinese economy is still growing strong and several signs indicate that the growth will actually pick up again next year. Even with the economic slowdown in China, employment has not dropped off as expected. Chinese growth is expected to pick up to growth of over 8% unless the US falls over a fiscal cliff or Europe cannot continue to resolve its financial woes.

Summary

Overall we expect that the US equity markets will remain robust and we don’t expect any significant downturns in Canada. However we think that the Canadian housing market has reached its peak and may be at significant risk if the Bank of Canada starts to raise rates next year.