The disconnect so far this year between positively surprising global economic statistics and falling equity markets is described by many commentators as highly abnormal, with the only precedent occurring in the early 1930s. There appears to be a great reluctance to recognise the extreme abnormality of the whole post-1997 cycle. Without going into a history of the past five years the equity/technology bubble has left us with (at least) three big problems with which equity investors are still struggling to come to terms.
The first is straightforward valuation. On reported trailing 12-month earnings the S&P500 index is trading at a price/earnings multiple of 41 – the worst case. On consensus ‘operating’ earnings for calendar 2002 the p/e multiple is around 21 – the best case. Yet on conventional models the best case p/e multiple of 21 is only just around fair value when compared with a 10-year US Treasury bond yield of 5%. So even after recent falls the US equity market has only just hit a commonly used measure of fair value. The UK and European markets look a little better on similar conventional valuation measures, but only a little. Perhaps things look better on 2003 p/e multiples. Well of course they do! Analysts appear to expect US earnings to rise by nearly 20% in 2003 to a level which would be around 8% higher than the level achieved in 2000 and representing a new peak in net income margins. How likely is this to occur?
Here of course we hit the second problem which the bubble has left us – the quality of earnings. Even if the underlying operating performance of the businesses which comprise the US stockmarket were to return to the heights of the boom, it has become very clear that earnings were (at best) overstated and (at worst) outrageously manipulated between 1997 and 2000, as a straightforward comparison between the vertiginous trajectory of S&P profits and the frankly pedestrian path of US whole economy profits measured by the National Income and Product Accounts can easily demonstrate. Standard & Poor’s themselves are addressing several of the key concerns including properly accounting for the cost of employee /executive stock options, pension costs, restructuring charges from ongoing operations and asset write-downs by introducing a new measure of what they are calling ‘core earnings’. This brings the advantage of greater clarity, but the disadvantage of bringing down the level of earnings for most, if not all, companies. For example, the largest company in the world by market cap – General Electric – reported ‘operating’ eps in 2001 of $1.42. S&P calculate GE’s core earnings to have been $1.11 – a reduction of more than 20%.
The third legacy of the bubble era is the well-known US current account deficit which is ballooning towards $500bn (E522bn). This is most often commented upon as being a problem for the US dollar, which indeed it is, and the dollar does appear set to decline further. The dollar’s recent decline against most other currencies only retraces 25% of its rise since early 1995. The current account deficit has more significance, however, by being the counterpart to the still extraordinary level of US private sector dis-saving – now being joined by the US public sector as the government has moved from surplus to deficit. While the US corporate sector has cut capital expenditure quite rapidly over the past year or so and moved back closer to financial balance, the household sector has continued to accumulate debt at a rapid rate. This is an unsustainable process which must eventually result in a rebuilding of saving. As saving is rebuilt, so private sector demand growth will fall short of potential, guaranteeing a disappointing medium-term outcome for US GDP growth overall.
This eventual rebuilding of saving is certain, but the timing is not. And here lies the strongest clue to how the US Federal Reserve is likely to behave. Interest rates were cut, post 11 September, to the ‘emergency’ level of 1.75% in order to avert recession. The US economy grew at an annual rate of 5.6% in the first quarter of 2002 and where are interest rates today? – still at the ‘emergency’ level. The Fed knows that the bubble (which it helped to create) has left behind what could well be described as a savings time bomb. By keeping rates low, the Fed is praying that the recovery in saving will be slow. A rapid rebound in saving would ensure a recession. Rates are therefore likely to remain unusually low, though not necessarily at precisely today’s level, for some time to come.
The bottom line for strategic asset allocation follows logically. Equities are at best fair value and the earnings outlook is risky, on top of which the medium-term outlook for US growth is also risky. We are underweight equities in global balanced funds. Bonds will be supported by a continuing low level of interest rates, but may be concerned at times by the Fed’s single-minded focus on growth regeneration. We are neutral bonds in global balanced funds. Although cash returns are low, we are overweight. Equity risk is high while prospective medium-term returns are still, even from current levels, low.
Chris Carter, is head of strategy at Investec Asset Management in London

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