Investment Week - Too Far, Too Fast?
19 November 2009
With fiscal and monetary stimulus appearing from all directions, the US GDP hit a positive 3.5% in Q3 2009, most likely indicating the end of the recession. However the strength of the recovery remains uncertain as various stimulus programs that boosted consumer demand for autos and housing, in conjunction with significant government spending, provided a meaningful portion of the gain. Like a diver returning from the depth of an economic abyss, the US economy needs to ascend at a measured pace to avoid negative side effects that could give the upward slope of the equity market a case of the bends.
The housing market is showing continued signs of recovery as the S&P Case-Shiller 20 city house price index looks to have bottomed in April of this year. The most recent data available for August indicates that home prices are up 5% from the lows. This is modest in terms of the peak to trough drop of 33%, but it does signal to those considering a home purchase that the housing market is not a falling knife to be avoided.
The consumer, which normally accounts for a large portion of GDP, has lost some ability and perhaps motivation to spend. The US unemployment rate, now over 10%, provides a major headwind to the US economic recovery that will need the consumer to participate. Those that remain employed are likely to restrain spending due to less job certainty and reduced borrowing capacity. The availability of consumer debt has declined as home equity withdrawal has been significantly curtailed and credit card lines are being cut in response to the current high loss rates and a change in regulation. The unemployed face a more daunting challenge as the average length of unemployment is longer in this downturn than in previous cycles.
Despite a mixed economic picture, the US equity market continues its climb. The S&P 500 index has ascended over 60% from the 9th March low in local terms. This has been led by the financial services sector which has more than doubled off the bottom and consumer discretionary stocks that have posted an 84% gain over the same time period. The list of laggards contains more defensive groups such as consumer staples, utilities and health care stocks. Valuation of the equity market, while no longer “cheap”, does not appear to be stretched. The price to earnings ratio of the S&P 500 was 16x as of the end of October vs. a multi decade average of 17.7x. The earnings yield of the S&P 500 in relation to real 10 year Treasury bond yields or the real 10 year corporate bond yield show the equity market to be moderately inexpensive. While difficult to know for certain, it may be that bonds are the expensive asset and equities may be fairly valued.
Bull Points
- Significant monetary and fiscal stimulus resulting in a normalisation of credit spreads and an increase in capital availability
- An apparent bottom in US housing prices
Bear Points
- Dismal labour market with unemployment over 10% and underemployment at 17%
- Despite dramatic drops in the growth in household and corporate debt, the level of debt to GDP remains elevated.
Jeff Morris CFA, Sr. Vice President (US), Standard Life Investments
This article was first published in Investment Week on 30th November 2009.
