A low valuation is not necessarily a cheap valuation. Cheap implies the low valuation is not justified and a higher valuation will follow. Just because the current valuation of the U.S. equity market is lower than historical averages does not mean it is cheap. It may just reflect the significant structural risks that we face in the U.S., Europe, the Middle East and China.
U.S. stocks appear to have resumed the volatile trading pattern observed over the past two summers. The first quarter’s impressive equity performance coincided with stronger economic data and the short lived perception of reduced risks from Europe following the European Central Bank’s (ECBs) long term refinancing operations (LTRO). Recent economic data, however, has been disappointing in comparison to the optimistic forecasts made earlier in the year when an unseasonably warm winter and seasonal adjustments had painted a rosier picture of the economy than warranted. Whether this weakness in economic data is a payback for the better than expected winter months or something more fundamental remains to be seen.
One bright spot in the U.S. has been the strength of the corporate balance sheet and solid corporate profitability. Corporations have benefited from modest economic growth, low cost of funds and strong cost containment. However, profit margins are currently high. Further progress requires cost pressures to remain muted, modest economic growth and productivity improvements to continue.
This perception is likely to be challenged in the coming months. Recent data show corporate profits fell 0.3% in 2012, for the first time since 2008. Whether or not overall U.S. corporate profits are truly in negative territory is unclear. Nevertheless, we can say with some conviction that profit growth is slowing. Corporations have benefited from incentive programs and low cost pressures such that even modest revenue increases have led to margin expansions. But further growth in profits without strong growth in sales appears doubtful.
We are in the midst of a third growth scare in the three years since the economy began recovering after the financial crisis. Each summer slowdown in the U.S. has been followed by unconventional monetary action by the Fed. But the market reaction to these actions has become progressively weaker and the exuberance over Europe’s bailouts of their sovereigns has become increasingly short-lived. Consumers are enjoying a windfall from declining energy prices while housing markets appear to be stabilizing. Still, the overall growth trends are slowing in the face of European financial turmoil, domestic fiscal uncertainties and slowing emerging markets. Most other asset classes are signaling caution as well, with significantly lower commodity prices, record low bond yields, stronger dollar and a renewed interest in domestic over international stocks. This caution is somewhat evident in the stock markets where defensive sectors have outperformed cyclical but domestic equities are not pricing in risks to the same extent other asset classes have.
We continue to recommend investing with caution. The risks we face are structural and large, not just cyclical. Measuring valuations against historical averages has limited value.