Investors continue to struggle with the agonizingly slow pace of progress in Europe. While Europe appears to be inching closer to fiscal integration, last week’s various announcements left many unanswered questions; mainly, it is still unclear if the bond market will give European politicians the requisite time to achieve greater fiscal union even though the rough outline of a plan is emerging. This is critical, as to a large extent the outlook for equities increasingly depends on the outlook for Europe. If a crisis can be avoided then stocks appear cheap.
Europe: Inching Toward a Resolution or Slouching Toward Gomorrah?
Last week’s announcements in Europe continued in the tradition of the past two years: The statements by the various European grandees were an improvement on the status quo and a step in the right direction, but the actions taken still fail to definitively settle the question of whether Europe will be able to tackle its sovereign debt problems or if the euro can even survive as a currency union.
On Thursday, the European Central Bank took a number of steps to ease monetary conditions. The ECB lowered rates by a ¼ percent, and, more importantly, extended the period that banks can obtain loans from 13 months to three years. The latter is important, as it will help provide a funding source for European banks now that U.S. money market funds are no longer willing to buy European bank paper. What the ECB did not do, and what the market really wants to see, is to increase its commitment to buying more Spanish and Italian debt.
The second act of the European drama occurred on Friday, when the politicians discussed their plans for further fiscal integration, most of which was leaked earlier in the week. While the European countries are inching toward common budget rules and more fiscal discipline, there are still many unanswered questions. The plan appears sensible over the long-term, but still looks inadequate in the short term. Specifically, there is still no clarity on whether the ECB will be more aggressive in “ring fencing” Spanish and Italian debt while these countries attempt to implement difficult and painful reforms. While there is now a vague road map in place, it is still not clear that the EU will have enough time to get to its final destination. In short, this issue is still not settled and will carry over into 2012.
Valuing Equities In a Binary World
While stocks were able to post modest gains last week, this had more to do with a continuing stream of better-than-expected U.S. economic data than confidence in European institutions. With Europe still hanging over the market, investors are left with the same conundrum: How do you value stocks given the potential for a European debt crisis?
In the absence of a meltdown in Europe, it is hard to argue that stocks are not cheap. As of November 30th, developed market stocks are trading at 1.5x book value and 12.5x trailing earnings. Emerging market stocks are even cheaper, trading at less than 11x trailing earnings.
However, this leaves open the very real possibility that stocks are cheap for a reason. Even leaving aside Europe, should valuations be low given economic stagnation in most developed markets? While this is a reasonable concern, in the absence of a European meltdown we believe that stocks have more than adequately discounted the anemic nature of the recovery.
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As we’ve written about in the past, our favorite measure of near-term economic activity is the Chicago Fed National Activity Index (CFNAI). This indicator is comprised of 85 different economic measures, and does a reasonably good job of forecasting near-term economic activity. Historically, the CFNAI explains roughly 45% of the variation in the next quarter’s GDP. Just as important, the indicator not only helps forecast U.S. GDP, but is also effective in predicting global growth as well.
While the indicator is still below trend, it has stabilized since the summer. In October the CFNAI rose to -0.12, its highest level since last March. At its current level, the indicator is suggesting that Q4 and Q1 U.S. GDP should be in the 2.50% to 3.0% range. Not great, but neither is this the recession that investors were discounting a few months ago.
The recent improvement in the CFNAI and the accompanying economic outlook is important for stocks. Intuitively, you would expect market multiples to be higher when investors expect strong growth, and compressing when a recession is more likely. In the past, this is exactly what has happened. Chart 2 illustrates the historical relationship between economic activity, measured by the CFNAI, and developed market multiples. In the past, this single measure of economic activity has been able to explain roughly 15% of the level of equity valuations.
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Today, global stocks appear extremely undervalued, even after taking into account the weak pace of the recovery (they appear even more undervalued when you take into account bond yields). If investors were simply looking at expected economic growth, you would expect global equities to be roughly 60% above current levels.
There are several explanations for this discrepancy. Despite the stabilization in most economic indicators, growth is likely to remain weak for years to come. In addition, there are reasons to believe that margins, which are still at historically high levels, will compress in the coming years. Investors are also worried – particularly in light of the recent failure of the Super Committee – about unresolved budget and fiscal issues in the United States.
But the main reason that valuations are this cheap is the prospect for a meltdown in Europe. This leaves investors with the same riddle they’ve had for much of the year. If Europe can muddle through, then stocks are arguably a buy, particularly relative to bonds. If Europe descends into a crisis, cheap valuations will probably not provide much downside protection. So the choice to buy largely comes down to expectations for Europe. As of last week, this remains an open question.