David A. Rosenberg is Chief Economist & Strategist at Gluskin Sheff, with a focus on providing a top-down perspective to the Firm’s investment process. Mr. Rosenberg has earned both Bachelor of Arts and Master of Arts degrees in Economics from the University of Toronto. Prior to joining Gluskin Sheff, David was Chief North American Economist at Bank of America-Merrill Lynch in New York and prior thereto, he was a Senior Economist at BMO Nesbitt Burns and Bank of Nova Scotia. Mr. Rosenberg has ranked first in economics in the Brendan Wood International Survey for Canada for the past seven years and was on the U.S. Institutional Investor All American All Star Team for the last four years.
IS THE RECESSION REALLY OVER?
Not necessarily, according to at least two officials over at the National Bureau of Economic Research (NBER). Robert Hall, who actually heads the Business Cycle Dating Committee, came right out and said yesterday that the group will “wait for activity to surpass its previous peak” and added that the “committee will have to reconcile positive GDP growth with shrinking employment … I personally put substantial weight on employment, so I may be leaning toward a later date.”
Well, that may have some serious implications for the markets because historically the S&P 500 bottoms, on average, four months before the recession ends and never by more than eight months. By the sounds of what Mr. Hall had to say, the recession may not end for another 6 to 12 months, which may mean that the March low … may ultimately be retested. What the market seems to be responding to is the consensus of economic forecasters because 90% of them believe that the recession is ending this quarter. (Of course, like the dog wagging its tail, the group is taking its cue from Mr. Market; and Mr. Market in turn is taking his cue from them … talk about a symbiotic relationship!)
To repeat, as we said yesterday, we believe that the equity market is early in pricing in a recovery. The S&P 500 has rebounded 49% from those March 9 lows. Imagine how abnormal a 49% rally over a five-month span — it’s unprecedented back to the 1930s. In the last cycle, it didn’t happen until February 2004 — 18 months into that bull phase where again there was tremendous policy stimulus and an oversold low to climb out of. In addition, household credit was expanding rapidly. Even coming into what was a secular bull market in 1982, it took a good seven months to rally 49% — and that was with the benefit of a V-shaped economic recovery. Going back to 1950, it has taken an average of around 18 months for the market to rebound 49% from a recession trough, not five months as has been the case thus far.
Let’s examine what the macro landscape usually looks like at that magical +49% point in the equity market rally:
• Real GDP had expanded on average by 4.5%
• Employment had rebounded an average of 850k
• The ISM had firmed to an average of 56.2 (the lowest print by this juncture was 53.9)
• Corporate profits had recovered 12.0%
• Bank lending rose an average of 5.0%
In other words, the market is way ahead of itself, because, as of the latest data points during this 49% rally:
• Real GDP is trying to make a cycle low
• Employment is trying to make a cycle low
• The ISM is off the low but still sub-50 at 48.9
• Corporate profits are still trying to make a cycle low
• Bank lending is still trying to make a cycle low
We have never before witnessed a stock market rally of this magnitude over such a short time frame; and absent anything more than tentative signs of economic improvement. The only rally of this magnitude was the wild bear market rally ride in 1930, which was followed by a resumption of the decline that finally bottomed 82% lower in 1932.
As we said last week, the equity market right now is priced for 40% profit growth and 4.0% real GDP growth in the coming year. At the lows back in March, we estimate that the equity market was pricing in flat earnings growth for the coming year (since that time, the S&P 500, by our reckoning, has gone from discounting $50 on operating EPS to just over $70). We’re not sure if pricing in $50 on earnings is truly an Armageddon scenario seeing as we were at that level in 2003, but let’s say that a really bad backdrop, especially for the financials, was priced out four months ago; by the same token, nirvana began to get priced in with this last leg up in the equity market that began just about a month ago. At best, the truth is somewhere in between, but it is not at 1,000+ on the S&P 500. Not at this juncture. This goes down as the mother of all ‘show me’ situations.
At any given moment of time, there are four variables that drive the equity market — fundamentals, technicals, liquidity and valuation. When you look at valuation metrics, namely price-earnings multiples, and for all the talk about how we were facing Armageddon back in March, the P/E multiple at those lows were actually nowhere near where they were in the 1930s. In fact, at around 12x, the valuation of the market was actually no better than the average at other market troughs. In other words, the market never got attractively priced enough at the lows, and now we have the most expensive stock market on our hands in over four years.
Compare and contrast that with the corporate bond market, where valuation is measured by the interest rate premium over government bonds, and indeed, if there is a case to be made that an Armageddon scenario was being priced in back in March, it was in the corporate bond market, not the equity market. Baa spreads, which I use since Baa is the median credit rating in the S&P 500, pierced 600 basis points late last year, which was not far off the spread levels seen in the early 1930s. As cautious as I have been over the economy, I doubt we were ever going to see the same default experience we saw in the Great Depression.
What has happened since that time is that those spreads have collapsed to just over 300 basis points, which is still above the peaks of the last two recessions. So, while the depression scenario has been priced out of corporates, this asset class, by my estimation, is still priced for 0% economic growth, while equities are discounting 4.0% real GDP growth in the coming year. In other words, there is still likely more opportunity for bad news to be priced out in the credit markets than in equities.
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