A taste of what lies ahead

by Levi Folk | March 12, 2007

The market turmoil that erupted recently is an excellent, albeit painful, reminder that international stock markets are risky, highly correlated and rely on strong economic growth in the United States. The recent selling has more to do with a slowing U.S. economy than any other factor, and investors should take heed.

Chinese stocks fell and the selling spread like a brush fire in a drought. In this case there was a drought of buyers across all markets except for those investing in U.S. treasuries and Japanese yen. Apart from these apparent safe havens, losses were widespread.

The sharp sell-off in China was a red herring for those connecting the dots to weakness in developed equity markets. Most foreign investors cannot even invest in China’s domestic market. The real catalyst is a slowing U.S. economy and the toll it is taking on the profit outlook for U.S. equities. Note the sharp rise in U.S. treasury prices, which appears to confirm speculation that investors are reacting to an economic slowdown.

The housing and auto sectors have taken two big bites out of the U.S. economy, with housing being the biggest potential source of weakness. Lenders in the U.S. sub-prime mortgage market have been burned badly after a reckless lending spree.

Investment banks are being punished for their past sins as middlemen in the mortgage securitization business. Goldman Sachs shares fell 10% recently and credit-default swaps, which provide insurance against default on Goldman’s corporate bonds, are pricing its debt at a notch better than junk, according to Bloomberg News. These fears seem overdone given that the lower-quality mortgage-backed securities business, where defaults have been high, accounted for less than 4% of fixed-income revenues with these institutions.

Yet if financial earnings are slowing, the U.S. stock market just might have a problem after a truly stellar run. Companies in the S&P 500 increased earnings per share (EPS) at double-digit rates for 14 consecutive quarters as of the last quarter of 2006.

But like all financial market records, this one appears to be ending. Analysts have significantly lowered their outlook for corporate profitability in the first quarter of 2007 to just 3.8% EPS growth, based on expectations that Thomson Financial tracks. Perhaps this is not all that startling given that fourth quarter 2006 corporate earnings growth, net of the financial sector’s contribution, increased at a tepid 2%.

Earnings growth is not the only thing to consider when assessing the outlook for the stock market. Prices count too. And many U.S. equity managers are encouraged by the fact the P/E ratio on the S&P 500 index is roughly equal to its 125-year historical average and has worked off the excesses that were built up in the late 1990s thanks to the tremendous earnings run.

If earnings are coming off a record run, however, perhaps a current P/E ratio is understating market valuations because earnings are expected to revert to a long-term historical rate of growth. Earnings, just like the economy, are cyclical. In that case, U.S. equities don’t look quite as rosy.

Valuations are far less compelling when based on the cyclically adjusted P/E ratio (based on a 10-year historical real earnings average) as calculated by Professor Robert Shiller of Yale University. In fact, U.S. equities appear overvalued, though far less so than in 1999. And that perhaps is what the recent bout of market weakness is all about: the confluence of still-high equity valuations and slowing economic growth.

Much of the outlook for global equities hinges on the U.S. economy. A slower U.S. economy will lead to tighter credit conditions globally through an improving trade balance. This is likely what was at play last week when global markets sold off.

Alan Greenpsan, the former governor of the Federal Reserve, spooked investors when he recently suggested the U.S. economy is heading for recession later this year. Upon further clarification he is assigning a one-third probability to a U.S. economic recession in 2007. His views are at odds with official Fed forecasts, but they carry an enormous amount of weight on Wall Street.

None of the aforementioned points necessarily preclude the market from continuing on its rally. However, unless the U.S. economy is able to dodge some well-aimed bullets, investors are increasingly likely to call the market’s modus operandi into question.