Corporate earnings should rebound with recovery
After its peak back in the late nineties, corporate profits have gone through a see-saw, not rising much, but falling sharply with every global crisis starting with the burst of the technology bubble, back in 2001, and ending with the 2007 financial crisis. After the collapse of Lehman Brothers, equity valuation looked very cheap relative to most other asset classes, such as bonds, real estate and cash and gold. At the time equity risk premium had risen sharply, mainly in the emerging markets, and recently also in the Euro zone markets. With central banks around the world pushing interest rates to record lows, inflation falling in line on the back of sharply rising unemployment, and with falling commodity prices, government and corporate bond yields fell steeply.
Equity investors started looking for safety. Initially they raised cash, and then some of them moved to other asset classes such as bonds and real estate investments. This process pushed equity valuation to extremely attractive levels that had not been seen in a long time. The very cheap equity valuation was justified - as the risk of the Euro Zone breaking up and the fragile US economy were seen by investors as a reason to avoid investing in equities. By the middle of last year, investors concluded that economic conditions and risks were fully priced into equity valuation and that it was worth gradually stepping in. Equity markets started the recovery and the momentum picked up: investors had started to realize that all the measures taken by central banks would ultimately lead to economic recovery.
I think that the initial recovery in the stock markets may be over and we now face the tough task of identifying those markets and sectors that will benefit mostly from a global economic recovery in the next few years. Investors should focus on those markets and sectors that will be driven by earnings and dividend growth. Hopefully, and assuming that we do not face any crises, profits should grow as world economic growth returns close to trend rates in 2014 and accelerates into 2015. The good signs are there already. The Euro Zone it seems has come out of a deep recession, and a slow and sustainable recovery is perhaps on the way. Also, with emerging markets finally giving in to foreign exchange correction, and in some places actual devaluation, an economic recovery lead by exports may be coming at last.
This global economic recovery will certainly be accompanied by continuing low inflation and high unemployment. There is also the issue of a big build-up of excess capacity and a larger pent up demand. The latest Federal Reserve decision to not scale down on its monthly bond buying operation has sent a clear signal to other central banks that the low interest rate environment is here to stay for a much longer period. I don’t want to call it a ‘Goldilocks’ scenario, but there are some similarities to previous times when equity markets were at their best. Perhaps the clear signal to investors will come from the corporations themselves. We have already seen a big buy back in the US and lately some pick up in, either the management buyout, or the merger and acquisitions activates. We all know that cash levels at the corporate level are extremely high.
As fundamental economic conditions change, so should the investors style of investment. The selloff in bonds and rising yields should make companies that offer high dividend yields less attractive to investors. Also, some of the defensive sectors such as utilities, food and pharmaceuticals could start underperforming in the coming months. I believe that investors should look for those companies that have a strong balance sheet, a good dividend yield and strong earnings growth potential.