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Is this a market recovery or a false start?

25 September 2009 Gareth Stokes
Gareth Stokes, FAnews Online Editor

Gareth Stokes, FAnews Online Editor

The JSE All Share index has surged 40% since its 9 March 2009 low. Measured in US dollar terms investors have doubled their capital in just six months. This scenario has played out on equity markets across the globe. Developed world markets are 62% higher

Is this a market recovery built around economic fundamentals, or have the runners jumped the starters gun? In their Q3 2009 economic update, Sanlam Private Investors (SPI) set about answering the question: “Is this a false start?” According to Alwyn van der Merwe, director of investments at SPI, the answer is a confident no! He discussed four conditions that suggest the recent market turning point was indeed a starting point for a sustained recovery.

Four conditions for a legitimate start

The first condition is that prices of risky assets must be low. A quick look at the MSCI indices for developed and emerging markets suggests that equities had shed significant value by the beginning of March 2009. Locally listed share prices had fallen steeply too, hovering near their lowest levels in 36-months. “From a South African perspective the starting point was in the right place,” said Van der Merwe. Using a slightly different measure Van der Merwe confirmed this condition for the US market too. Using normalised cyclically-adjusted earnings to create a price-to-earnings curve he demonstrated that the US market dipped below its 110-year average for the first time in nine years around March this year. Equity valuations in South Africa, the US and most of Europe were similarly subdued, suggesting the market recovery indeed started when so-called risky assets were ‘cheap’.

The second condition is that economic woes must still be evident when the turnaround begins. It’s a strange requirement, but necessary because the real economy usually lags equity markets by some margin. In the absence of these conditions one would have to question the ‘normality’ of the market. The third requirement is for an aggressive policy response from governments. We already know that the US Federal Reserve response to the financial crisis is unprecedented. Governments around the world did everything they could by way of monetary policy and fiscal stimulus as the global financial market teetered on the brink of collapse. Most governments have persisted with quantitative easing steps through the first half of 2009.

A fourth condition is that cash levels must be high, while equity levels are low. A comparison of total investments in US equity versus Money Market funds is self explanatory. “There was a lot of ‘powder’ that investors could use to buy equities,” said Van der Merwe. The situation was exacerbated by shocking returns on cash investments. As we enter the final quarter of 2009 there’s still plenty of cash waiting to re-enter the equity space. This suggests any short-term pullbacks in the recovery could be ‘plugged’ by low-yield risk-seeking cash.

A very different economic cycle

Many investors are concerned with the glaring disconnect between equities and forecasts for global growth. GDP growth forecasts for 2009 – published in May this year – suggest declines in the US (-3%), UK (-3.7%), Eurozone (-3.7%) and Japan (-6.5%). These numbers hardly inspire confidence.

One way to deal with the phenomenon is to consider the current economic cycle. The path of recession that played out in the US (and later in South Africa) is markedly different from the ‘typical’ economic cycle downturn. In the ‘typical’ cycle the downturn starts when the economy is producing above capacity. But today’s downturn started with excess debt in the system. Instead of monetary tightening (in a normal cycle) we ended up with bad debts, profit warnings and a severe sell-off of risky assets. As equity prices fall the economic slowdown accelerates. In a ‘typical’ cycle a recession is followed by monetary easing. In today’s cycle this monetary easing preceded recession – speeded up the rate of economic decline – and led to a second round of risky-asset price cuts. The monetary response to this was to drop interest rates to almost zero in order to break the so-called credit cycle.

Nothing happens without earnings!

According to Van der Merwe South Africa’s share price recovery is largely driven by a market re-rating. The price-to-earnings ratio of the entire market has recovered to 13.89 times against the long-term mean of 11.72. The re-rating (and near 40% recovery in equity prices) is consistent with previous recoveries. The average equity market gain measured after nine previous recessions is 62%! There is only one way this momentum will remain. “You need earnings to sustain the recovery,” said Van der Merwe. In other words – the outlook for South African equities hinges on future corporate earnings. If earnings contract by 10% over the next 12-months, then the price-to-earnings ratio of the market is going to climb to 16.5 times, which is historically expensive. We’ll need earnings growth of close to 23% in the coming year to re-rate the market to its mean. The consensus earnings growth forecasts for South Africa are for an earnings contraction of 11% this year, followed by 18% growth in 2010 and 21% growth in 2011.

The domestic equity market recovery is at an interesting stage. Right now we’re in an ‘overshooting’ stage confirmed by earnings upgrades and ideal conditions for momentum investors. They will ride the recovery sentiment higher. If this sentiment prevails for another quarter or two the local market could well enter the ‘bubble’ stage. This stage is defined by excessive optimism on return on equity and earnings growth. Van der Merwe warns: “We’ve seen a phenomenal recovery – but what we tell our clients from a top down perspective – is you’ve got to moderate your expectations!”

Editor’s thoughts: The experts remain bullish on carefully selected equities. Sanlam Private Investments likes shares like British American Tobacco (for its consistent dividend yield) and Steinhoff International (for its cyclical growth prospects). But overall market returns are likely to be unimpressive over 2009 and 2010. Are you still confident in equities as an asset class? Add your comments below, or send them to

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