Some market watchers may now be wondering what the slowing recovery means for equities.
Since the end of April, most economic reports have ranged from the sobering to the truly awful, and there is little doubt that both the US as well as the broader global economy are in the midst of an economic slowdown.
While recent economic data is not signaling another recession, at the very least it does suggest that the first quarter’s weakness was not a fluke or simply the result of bad weather. As we have mentioned, we now expect that growth in this second and third quarters is more likely to resemble the anemic pace of the first quarter rather than the more robust expectations of 3% to 4% growth that many investors had been expecting as recently as March.
While there are periods in the market when weak growth is actually welcomed by investors, this is not one of them. With most economies still trying to claw their way back from the financial crisis, investors in developed markets are more worried about growth than inflation. While we agree that recent economic numbers are negative for equities, and are likely to lead to a period of higher volatility than we experienced during the first four months of the year, we also continue to believe that much of the bad news is already reflected in stock prices.
While leading indicators of economic growth have turned down, the dip appears to already be reflected in valuations. Currently, global developed markets are for the most part trading below their historic valuations. When we compare the current level of leading indicators with the valuation on the S&P 500, we arrive at a “fair value” of around 2.80 to 3.0 times book value, rather than the current level of 2.15.
Some investors will rightly point out that the US and global economies are facing more headwinds – slower growth, higher sovereign debt, geopolitical unrest in the Middle East – than in the past, and therefore stocks deserve to trade at a discount. To a large extent, we would agree with this assertion. However, by most measures it seems that the current discount is still more than adequate to account for these real and potential headwinds.
In short, while we have been arguing for months that the summer is likely to be characterized by higher volatility, we believe that absent a more dramatic economic slowdown, equity markets still appear reasonably valued. In addition, the fact that equity valuations already reflect much of the bad news should help to cushion the near-term downside for stocks. And over the long-term, equities still appear to better reflect the world’s risks and worries than their pricier cousin, bonds.
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Disclosure: Author is long IOO.