Stocks looked cheap on most measures even before this week’s global equity market rout. But that should provide scant comfort to investors in the current environment. With so much uncertainty surrounding the state of the US economy, the future course of central bank policymaking and the outlook for corporate earnings, there’s a good chance they will get cheaper still.
Following the 7% sell-off on Monday, European markets are now down 18% from their peak in October. That makes this already the sixth biggest European market correction since 1969, according to Lehman Brothers Inc. research, while on an annualized basis, the speed of the fall has only been exceeded once—in 1998. The US markets were closed on Monday so were spared the latest carnage, but the S&P 500 is already down 14% from its peak and futures markets are pricing in a further 4% fall on Tuesday.
At these levels, stocks certainly look cheap, provided you believe current earnings estimates. The global price earnings ratio is just under 12 times—some 8% below its previous trough reached in 1990, according to Lehman estimates. Meanwhile, the yield gap, defined as the difference between the earnings yield on equity and the yield on debt, is also at its widest for 30 years.
The snag is the market rightly no longer has any confidence in earnings estimates. Analysts have a long and undistinguished history of failing to spot turns in the earnings cycle. There is currently a major disconnect between top-down forecasts of earnings by economists and bottom-up earnings estimates by sector analysts.
The market currently seems to be pricing in a 25% fall in European earnings. That would restore the market multiple to its long-term average of around 14 times. On the same basis, the US stocks seem to be discounting a similar fall in earnings. Those are much bigger falls in earnings than currently forecast.
They are also big in historic terms too, only the 1989-93 slump in European earnings and the 2001-03 US slump have seen bigger peak-to-trough declines. But that will provide scant comfort to investors. There is too much uncertainty to put a floor on valuations.
Meanwhile, the longer the stock market slump continues, the greater the chances it becomes self-fulfilling. Big losses can hit consumer confidence, while firms faced with a higher cost of capital may postpone investment decisions. It is not yet time to go bargain hunting.