It is fair to say that investors in stock markets are pleased to get 2011 behind them. Having dined on an unremitting diet of bad news, in the form of the Arab spring (pushing up oil prices), the Japanese Tsunami, the first ever downgrade of America’s credit rating and an interminable game of Russian roulette being played out in the EuroZone, capital losses of just under 10% in the World Equities (as measured by Morgan Stanley) for Sterling Investors over the course of the year seem relatively modest.
As anyone who reads the financial press will know however, the EuroZone sovereign debt situation remains an unresolved issue with the potential still to precipitate a sharp correction in equity markets if, through incompetence or institutional incapacity the Euro fragments, thereby globalising the already inevitable European recession.
Discounted bad news
However, in contemplating the prospects for the coming year we should also consider the reasons for the resilience of share markets hitherto. The first reason is valuation. Shares are most vulnerable to bad news when shareowners are expecting good news. These expectations are crystallised in the valuation that the investors are prepared to pay for shares, one measure of which is the Price to Earnings (PE) ratio. At the start of 2011, the PE ratio of the average World shares (as measured by the Morgan Stanley World Index, using already reported numbers) was low relative to its history at just over 14 – the average level since 1995 being approximately 20. Although there are many who say that even this level is too high in current circumstances (where there is a threat of an earnings decline in the coming year), such an observation misses the point, which is that valuations at the start of last year already reflected far more caution than complacency. This is even more the case today, with the PE ratio currently just under 12.5.
Blue Chips continue to deliver earnings
This brings us onto a second reason for share-price resilience over the past year, which is the performance of corporate profits (the “E” in the PE ratio). In spite of the confluence of unfortunate events and some resultant slowing in economic momentum, global blue chip companies delivered solid earnings growth. This year, only forecasters wearing the most rose-tinted spectacles could expect more of the same, but with many forecasters suggesting that market levels are discounting a decline, any signs that this not on the cards would be enough to confound the bears.
Equities Versus Bonds
A third reason for share price resilience last year was the dwindling of secure options for long-term investors looking to generate income. With the 10 year bonds of prime-credit governments delivering yields of little more (and often less) than 2%, dividend yields of over 3% available on the shares of many global blue- chip companies have become attractive by comparison – particularly when additionally considering the potential for that dividend to grow and their more diverse currency exposure.
In summary, it is clear that we are in a period of high risk, with the first quarter likely to present some testing moments as Europe wrestles with its structural issues, but low valuations relative to history and an attractive alternative to low yielding government bonds for longer term investors clearly both remain supportive factors. The earnings picture is more difficult to call, but our sense remains that investors are largely braced for the worst and would be far more surprised by good news than by bad. Once the first quarter is behind us, we would expect a more forgiving climate to predominate.