Green Shoots Need Food and Water

04/28/2009 12:00 pm EST


Alexander Young

Equity Market Strategist, S&P Capital IQ

Alec Young, Standard and Poor’s equity strategist, says the big rally already discounts a “less bad” economy, and investors will have to see more to push stocks higher.

After an extremely volatile start to the year, stock markets [have] rebounded sharply since early March. Tentative signs of global economic and credit market stability, coupled with compelling valuations, fueled the advance.

While global macroeconomic news isn’t encouraging, investors are hoping that the situation will not deteriorate further, which could set the stage for a gradual return to positive gross domestic product (GDP) and earnings per share (EPS) growth by 2010.

Through April 20th, emerging markets showed the best gains, [while] developed markets remain modestly lower year to date, with the United States outperforming Europe and Japan.

By early March, given the amount of negative news that we believe was discounted in equity prices, the US was trading at only 11x 2009 estimated EPS, overseas developed markets were trading at a mere 8.7x, and emerging markets [at] only 7.9x. Therefore, it is not surprising to us that at the first concrete signs of recovery, equities would enjoy some overdue P/E expansion, as investors finally had the confidence to envision better days ahead.

All that was needed was a catalyst, [and] we believe that came in the form of economic “green shoots.” Specifically, China’s aggressive domestic stimulus spending appears to be helping offset export manufacturing weakness driven by OECD recessions. While Standard & Poor’s still expects China’s GDP [growth] to decelerate to 6.5% in 2009 from 9% last year, markets had been concerned the slowdown would be even worse.

In addition, many US economic data series stopped deteriorating, spurring hopes of a gradual recovery by late 2009. The US economy represents 23% of global GDP and 30% of global consumption, highlighting the importance of a US recovery.

S&P Equity Strategy believes confidence is driving emerging market (EM) “alpha” relative to global benchmarks: Once the global economy recovers, this asset class’s faster secular economic and EPS growth should resume. We believe China’s recent economic stabilization only reinforced this view.

We believe that after the major global equity rally, which began on March 9th, much of the nascent fundamental improvement is priced into worldwide stock market valuations. The Standard & Poor’s 500 index is trading at about 14x 2009 estimated EPS, while developed overseas equities are fetching 12.7x, with EM equities trading at 11.8x.

While we are confident global equities saw their cycle lows, we believe greater evidence of global economic and credit market stability will be needed to fuel meaningful near-term up side from current levels. We think markets will likely be higher in a year, but we would not be surprised to see some near-term consolidation of the recent advance as investors await more evidence of improvement.

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