What is positive for the market heading into 2012?
Well, it’s not any shift in my view on the U.S. economy. If you average out the wiggles, the real GDP growth south of the border was at best 1.7 per cent in 2011, far short of the 3 per cent that people expected at the beginning of the year.
Leading indicators for the year to come are not behaving particularly well. The economy still faces headwinds, none stronger than the looming hit to exports, manufacturing activity and profits from even a mild European recession.
My fundamental view on the U.S. stock market hasn’t changed either – we are still in a bear market, marked by tremendous volatility. You can’t overlook the fact that the 18-per-cent rebound that has occurred since October came on the back of a 19-per-cent collapse from July.
What has changed are valuations and investor expectations.
Let me explain.
The story for 2011 was one of a contraction in price-earnings (P/E) multiples as initial optimism faded and investors grew more averse to risk. Despite solid growth in operating earnings-per-share, the U.S. stock market ended largely flat.
What held the market back was the multiple, which contracted from a P/E of about 15 to nearly 12. The P/E multiple is essentially a measure of how much investors are willing to pay for a dollar of earnings. A swing of a single digit in the P/E multiple equates to nearly a 100-point shift in the S&P 500. This often counts more than earnings do when setting targets for the year.
We have a situation now where the P/E ratio, based on the trailing 12 months of earnings, is a mere 13. That may not be a classic trough by any means, but only 20 per cent of the time in the past quarter-century has the multiple been this low. That is something for investors to consider.
The multiple based on estimated earnings for the next 12 months – the “forward” P/E – is less trustworthy than the trailing P/E because it depends on analysts’ ability to accurately forecast the coming year. But as it stands, the forward multiple is now just a snick below 12.
In the past quarter-century, we saw only one other time when it was this low on a one-year forward basis, and that was the first quarter of 1988. A year later, the S&P 500 rallied 15 per cent.
That, too, is something to mull over.
One must keep in mind that valuation is not a timing device. If all you did was focus on such metrics, you would have missed out on the final three years of the late-1990s tech boom. That said, paying attention to P/E ratios can also help keep you out of trouble – like the tech wreck of the late 1990s.
At their current low levels, the market’s relatively modest P/E ratios bolster confidence that this market is unlikely to take a devastating plunge. One could even argue that equities at current levels, with current earnings expectations, are good value.
There is the possibility that things could go better than expected. Among other positive influences, the Chinese central bank is easing policy and the European Central Bank is cutting rates. Expectations are also more realistic than they were a year ago.
The big question now is whether the market’s price-earnings multiple can expand in 2012. The next few weeks will be key as companies announce their fourth-quarter earnings.
While I’m still on the cautious side, I see the case for why the floor for investors’ expectations may be higher than it was before. The key going forward will be how corporate profits perform in the low- to no-growth environment I see ahead.
In the meantime, you did read correctly: There is actually something going on out there on which I am not entirely bearish.