Is It Valuation or the Economy?

Not just from the young and restless, in June/early Aug. 2009 chatter grew about valuation expansion as market driver. We unequivocally do not consider the current environment to be of valuation expansion but instead dependant on duration and extent of recovery. Our valuation range ( 15-18x) implies that in five months since the 2009 lows, roughly half of the incorporating took place of earnings recovering to their prior peak (2006 at 88 for the S&P 500), leaving the second half of market recovery for the subsequent thirty months through 2011. In our view, the pace since March 2009 is likely too rapid. At the industry level, corporate recovery has not a-priori meant valuation expansion. In the highly diverse U.S. market, equity earnings valuation last peaked in 1999 and made no headway in the strong growth/ low rates of the 2000s. Even more extreme is Japan since 1989.
Even the new global growth citizens of China and India have had their valuation peaks back in 2006/7. The extension of quantitative ease by the Bank of England, as well as commentaries from the Federal Reserve, the European Central Bank and various authorities in China are indicative of continued angst. For the markets, the challenge of economy/earnings gains is likely to shift and be the more important over valuation expansion. Driven by restructuring growth in emerging countries like China as well as leveraging up by consumers like in the U.S. and risk misjudgments in capital markets, global growth of GDP peaked at over 5% in 2006/7. Coming out of recession, US GDP recovery in Q3/2003 was actually 7.2% annualized, compared to which even 2.5% annualized for late 2009 would be modest. In China, restructuring and exports pushed GDP growth to 13% by 2007. Now, front loading of Chinese stimulus and massive bank lending of Renminbi 7 trillion has managed to boost GDP growth closer to 7.9% annualized. We see revenue recovery for corporations as being one of duration, not as imminent notwithstanding the recent equity surge or the last expansion from 2002. We have been monitoring the corporate reporting cycle with its commonality of severe cost cutting and revenue pressures across industries. Compared to the last two cycles, now a corporate delivery risk is likely that forced cost cutting increases bifurcation between companies within industries due to differentials like balance sheet strength, management acumen and product leadership. We believe in investments, a quality overlay remains preferable.

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