Sent: 06-07-2010 12:21:06
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Coping with Lower Growth
World stock markets are adjusting to weaker growth before beginning to rise again.
Many of the current concerns about economic growth have their source in the global credit crisis. However, the possibility of a medium term slowdown in growth and lower investment returns was evident well before 2008. Some of the reasons for this were discussed in Edition 40 of the ATC Digest in May 2007 (see "Long-Term Growth: Changes to Likely Investment Returns").
Commonly in economics, it is relatively easy to understand the current circumstances in which we find ourselves; a little harder to understand where we should be but extraordinarily difficult to work out how we make the transition from where we are to where we should be.
That we are in the midst of a transition to lower growth and more appropriate equity market prices is now becoming clearer. While investors fought hard to prevent the inevitable and conjured up some imaginative and misleadingly attractive new products to help sustain impossibly high returns, they are recently succumbing to the new reality.
Markets tend to rise only after they have got down to a level from which reasonable returns can again be generated. In seeking out that level, investors risk the opposite danger of markets being pushed to unsustainably low levels that imply slower economic growth rates than will actually prevail. Coping with Lower Growth
Any market value implies a set of earnings and growth assumptions. The U.S. S&P 500 is a case in point. At 30 June, the S&P 500 index was at 1030.7. S&P 500 earnings in 2009 were $56.86 per share.
According to S&P analysts, earnings are likely to grow by 44% in 2010. This seems a fairly robust outcome against a backdrop of a slowing U.S. economy. However, most of this growth can be attributed to the build-up in momentum which already happened in 2009 and early 2010. Even in the event that S&P 500 earnings do not rise any higher for the balance of 2010 than the March quarter level already attained, growth for the year will reach 37%.
Let's assume that the S&P analysts are right. What should we be prepared to pay for the S&P 500 basket of stocks? One approach to working out the appropriate price/earnings ratio uses the Gordon growth model framework in which the price/earnings ratio will depend on:
- the targeted rate of return;
- the dividend payout ratio; and,
- the future growth rate in earnings.
Let's assume that our target rate of return is the sum of the current U.S. 10 year bond yield (i.e. 3.0%) and an equity risk premium of 6%. A reasonable dividend payout ratio might be 40% (compared with 39% over the 20 years to 2007). Let's assume also a growth rate of 6¼% based on 2½% inflation and 3¾% growth in sales volumes.
Together, these assumptions suggest a price of 1190 or a 15% increase over the 30 June level of the market. The same assumptions and a price of 1030 implies a belief that earnings growth in 2010 will be just 25%. If this eventuated, U.S. corporate earnings would not just have grown less quickly but would have actually gone backwards in the balance of the year.
Of course, as we have learned, it would be foolish to derisively discount this possibility. However, the importance of the example is that it offers a basis on which an investor can choose the assumptions which best match their view of the world and, having done so, derive the price up to which he should be prepared to pay for an equity investment.
An assumption of a stronger macroeconomic environment with sales growing at, say, 7.0% would imply an index value close to 1500 or a 45% uplift in the market and a strong basis for concluding that the market is already too weak. Similarly, weaker growth of, say, 5% would mean another 20% downside in the market to 820 and a conclusion that the market is not yet weak enough.
The leverage to a change in growth is very strong. This is why the downward market adjustment to accommodate lower growth expectations has had to be so severe. It also suggests that any overshooting as a consequence of an overly pessimistic outlook near the turning point of the market could result in a very dramatic eventual catch up.
This email is general in nature only and does not constitute or convey specific or professional advice. Legislation changes may occur quickly. Formal advice should be sought before acting in any of the areas discussed. Be aware that the information in these articles may become innaccurate with time. Responsibility is disclaimed for any inaccuracies, errors or omissions. Particular investments are neither invited nor recommended and hence this publication is not "financial product advice" as defined in Section 766B of the above legislation. All expressions of opinion by contributors are published on the basis that they are not to be regarded as expressing the official opinion of any other person or entity unless expressly stated. No responsibility for the accuracy of the opinions or information contained in the contributor's articles is accepted by any other person or entity. Copyright: This publication is copyright. If you wish to reproduce this article you require a license, which can be purchased here, to do so.