Global equity strategyGY
Asset allocation: Half way through a bear market rally
Two weeks ago, we highlighted that we were becoming less bearish but were waiting for clearer capitulation.
We did not quite get capitulation on the scale that we had envisaged (the aggregate indicator did not quite reach Jan 21st and March 17th lows) but three of the sub indicators did get there over the past week:
(1) Markets were exceptionally oversold (less than 20% of stocks were above their 10-week MA for 10 consecutive days - the only time this happened before was July 02 and May 04, which then saw an average gain of 12% over the next month).
(2) Equity sentiment was as depressed last week as it was at the lows in Q1.
(3) Insider (i.e. management) buying rose to levels consistent with a temporary low, with corporate net buying (data just out) now back up to normal levels. On top of this, we have the catalyst of a falling oil price (with each 10% off the oil price adding 0.2% to GDP and reducing inflation by 0.3% at a time when central banks are focused on inflation!).
The average bear market rally has been 15% over 51 days and on that basis we are about half way through the rally (though the risk is that with less capitulation than March 17 lows - the rally is less).
Why a bear market rally not a bull market?
(1) Valuations are cheap but should be cheaper
: the equity risk premium oour earnings numbers is 3.8%. This is 'cheap' in as much as it is 40bp above its long-run average but the warranted equity risk premium (based on credit spreads and lead indicators) is now at 4 ¾%. The problem is that bond yields did not fall that much into the last down-leg in equities (when the S&P 500 was last at this level in mid-March the US bond yield was 80bp lower!). We do not hit an equity risk premium of 4 ½% or more until the S&P falls to a 1,150 to 1,200 range. Additionally, at 1,170 S&P 500, the multiple on trend earnings would be the same as Oct 2002 market low (of 15.6x). (2) Our models suggest 2009 EPS will fall by 20% to 30%. (3) To get more positive on the economic backdrop we have to see the ECB target growth not inflation (and we think that will not be until Q1 2009) OR oil falls sustainably below $110pb (again unlikely until we have seen more demand destruction in Europe/US). (4) The average bear market during a recession has been 28% over 13 months – as of now, the US is down 17% over 9 months.
Our biggest fundamental concern is that the central banks continue to overly focus on commodity led inflation (where resource constraints continue to negatively surprise) and as a result exacerbate a credit led deflation (that has on our data hardly started with both US bank leverage and on some measures US consumer leverage higher than a year ago). Hence, we believe that global GDP growth will slow to around 2.8% over the next year (compared to 4.9% in 2007)
. We continue to prefer credit to equity with, outside the financial sector, the earnings risk being higher than the balance sheet risk. We stick to our yearend target of 1,300 on the S&P 500 and 320 on Eurostoxx.
The fundamental view: only a bear market rally!
(1) Equities are cheap but should be cheaper on our models.
(2) 2009 EPS estimates need to fall at least 20% on our models (in Europe probably closer to 30%).
(3) We need to see oil falling sustainably below $110.
(4) We need the ECB to target growth, not inflation.
(5) In a recession, the average bear market is 28%
(that would imply a low of 1,140 S&P 500).
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