Equity Outlook Still Rosy Amid the Thorns of Uncertainty

The stock market outlook remains rosy despite last week’s widespread uncertainty, with the major indexes suffering from mild profit-taking and the publication of some negative data on the U.S. economy. Mounting expectations that the ongoing economic recovery will gather further pace in the first half of 2010 are the main reason behind the persistent uptrend in stock indices.

Notwithstanding a high degree of skepticism about the duration of the economic recovery (some economists indicated that it will only depend on the fiscal and monetary stimulus packages implemented by the governments. This emphasizes the risk of a relapse into recession in the coming quarters) the leading international institutions are revising up their estimates for 2010 and 2011. Last week, the OECD upgraded its 2010 growth forecasts for the biggest international economies (the 30 member countries are now seen gaining 1.9% vs. +0.7% last June), and for the first time, released its growth projections for 2011, which foresee a continuation of the global recovery (+2.5%).

The equity market upswing also reflects the acknowledgement that major central banks will continue to pursue an expansionary monetary policy going forward. The Fed, ECB and BoE are not expected to raise rates in the first half of 2010, and might even leave them unchanged until late next year. As the Bank of England Governor Mervin King suggested speaking about UK economy during the presentation of the latest “Inflation Report”, a short-lived return of the UK GDP to its pre-crisis level would not be enough to make up for what the country has lost over the last two years.

Expectations that major central banks will not tighten rates for a long time are impacting the Government yield curve: the differential between the 10-year and 3-month government Bond yields is over 300 basis points in the U.S. and UK and more than 280 basis points in the euro area. The graph below shows that a very steep yield curve has been traditionally followed by a very positive performance during the following 12 months in the S&P 500, the leading indicator for the overall U.S. stock market.

As we suggested in the post “S&P 500: a mildly positive outlook ," the S&P 500, with an average P/E ratio for the past 10 years of 19 (broadly in line with the post-WW2 average), does not look overvalued, despite the strong rally staged in recent months. Given the positive outlook for the S&P 500, with a consequent positive impact on the whole of international indices, we recommend overweighting other equity indices.I ndeed, the weak dollar is a great concern for the U.S. stock market.

Over the last few months, there has been a strong reverse correlation between the U.S, Dollar and the S&P 500. The equity market rebound has combined with a fall in the greenback and vice versa. Therefore, a new rise in equity markets might prompt a further drop in the U.S. currency, even though many indicators (including the OECD’s Purchasing Power Parity) have suggested that the US Dollar is more than 20% undervalued against the Euro.

By contrast, emerging markets, which are benefiting from a reduction in the size of the financial risk premium, should be favoured more than the developed countries by the international recovery, even due to currency appreciation. Although the risk/return profile of emerging markets has worsened in the wake of the sharp rise since last March, we recommend betting on a continuation of the emerging markets uptrend.

Author's Disclosure: I am long Chinese, Brasilian, European emerging equity markets

Comments

[conceptwizard]

When currencies are being debased, volatility in the stock market increases. But the gains are not worth the risks and if anyone is still in the market, they will be wiped out by the 1st quarter of 2010. The S&P may have shot up since the beginning of the year by over 25 per cent but it has been out-performed by gold. The gains have also lagged behind the official US inflation rate. It has in fact delivered a total return after inflation of approximately minus 25 per cent. When Meredith Whitney remarked that, “I don’t know what’s going on in the market right now, because it makes no sense to me”, it is time to get out of the market fast.

In a report to its clients, Société Générale warned that public debt would be massive in the next two years – 105 per cent of GDP in the UK, 125 per cent in the US and in Europe and 270 per cent in Japan. Global debt would reach US$45 trillion.

At some point in time, all these debts must be repaid. How will these debts be repaid?

2009 Nov 23 10:30 AM

[Gordon Akman]

Rosy is not the word that comes to my mind.

2009 Nov 23 04:29 PM

[LaChic]

the only stock is worth holding right now is amazon for many reasons, one important one is the flu going around, many folks especially women are shopping on online. I also think earnings will be excellent once again for amazon...Walmart is also a good one if not for the dividend, Dollar Stores as well, not every dollar store, just the DLTR which is a true dollar store. Gold and Silver, the GDX and SLW, not to be confused with the SLV...those etf fees can add it up big if you buy too many of them.

I would sell everything else.....I think we are very close to the top on this market, a rally without a true recovery, yeah right!!!

2009 Nov 23 05:04 PM

[Paulo]

The retail investors I know don't think things are too rosy. The markets have risen far and fast this year and putting any new money in equities right now is perceived as very risky given the probability of diminishing returns on the upside and the possibility if not the probability of an eventual correction of some significance. As for bonds etc., the yields lag well behind the risks (and if you don't see them, you need a new pair of untinted glasses!).

2009 Nov 23 07:25 PM