Taking Stock

03/02/2012 at 11:57 am

Shares have enjoyed a strong start to 2012. The MSCI World Index of developed country stock markets closed yesterday up 6.5% on the year so far. The Emerging Markets index has done even better, closing up 13.9%. And yet looking at the headlines one might think this overdone. Banks in particular seem to be suffering, with Deutsche Bank for example reporting a 76% collapse in profits only yesterday. Last year markets were arguably too pessimistic in the face of mixed economic data and robust corporate earnings growth. Could they be growing too bold at present and overreacting the other way?

Let’s look at the S&P 500 index. Fourth quarter earnings season in the US is well underway, with just over half the members of the index (273 companies) having reported as of yesterday. Earnings per share for those companies rose 3.5% on the quarter, falling short both of analysts’ estimates (+4.8%) and the 5.4% rise in the index itself. On the face of it this could be taken as a sign of over-optimism.

Digging a bit deeper, however, we find that if we exclude results from the financial sector – which has posted a fall in EPS of over 18% so far – non-financial companies have reported an increase in earnings of 8.2% (against a forecast of +6.5%).

What is important about this is that it is the big banks which were most exposed to last year’s market turmoil. If Deutsche’s investment banking division, for example, had broken even over the quarter instead of posting a €422m loss, profits across the bank as a whole would have beaten analysts’ estimates. We have seen similar stories in US bank results, where poor performance from the market-exposed parts of the business masked continued modest improvements in key bread-and-butter measures such as the size of provisions for loan losses.

Even if we choose to ignore this level of detail, however, stock market indices have a long way to go before they begin to look overvalued. For example, the p/e ratio of the FTSE 100 index has averaged about 14 over the last ten years. Even assuming earnings growth of zero, to match this valuation from the current p/e level of 10.4 would require growth in the index of some 35% – a rise in price to over 7,800.

Of course, it is still possible that some kind of catastrophic collapse will overtake us, and market valuations reflect that fact. But it is at least equally possible that calamity is avoided, that the world’s tortuous recovery continues its uneven path and that over time even the wounds of the banking sector will heal.

The rally in equities so far this year has been swift, and rather surprising. Based on what we know about the valuation of stock market earnings, however, it is too early to say that price levels have got ahead of the fundamentals.


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