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First of all, history has shown that is much more profitable to be a buyer when fears have hit a crescendo while the best selling opportunities occur when investors are their most bullish and almost ‘complacent’ about the potential risks to growth. The chart below is BAML Sell Side Indicator, a composite reading of various sentiment readings of investment strategists. Extremely Bearish readings have been associated with market bottoms, including early 2009, while the Bullish indicator has gotten to extreme readings at market tops such as 2001 and 2007. It’s easy to see that the indicator has once again returned to the most ‘bearish’ level seen since the mid-1990’s, which indicates a potentially great buying opportunity emerging according to this ‘contrarian’ indicator. While an indicator like this is hardly infallible and we are much more interested in the economic outlook and overall valuation of stocks, it does help to highlight our view that great market bottoms are created when pessimism is rampant (as it is today) and investors have been getting out of stocks for a period of time (which is clearly true when we look at mutual fund flows into stock funds over the past four years).
Of course it’s not enough just for everyone to dislike stocks. We also need to have a fundamental reason to suggest stocks can go higher, including the potential for economic and profit growth as well as stock valuations that are below historical levels. On the latter point, stocks are definitely under-valued in our view. Of the many measures we look at for the Canadian stock market, one of our favourites has always been the UBS Model for Fair Value for Canadian stocks (shown below). The gray band shows the historical fair value for our stock market while the blue line is the actual index level. Outside of the huge overvaluation of stocks during the late stage of the technology ‘bubble’ (1999-2001 period), the market has been within the Fair Value (FV) range for most of the past 25 years. The stock market dropped well below the FV after the financial crisis but then rallied sharply over the next 18 months to close that gap. Since early 2011 however, stocks in Canada have drifted lower while the FV for the market has moved higher due to earnings growth.
So now we find stocks at their biggest discount to this FV indicator in the 25-year history of the model. Pessimists are always quick to say that maybe the model has stopped working for whatever reason and that stocks are not really cheap. But our view is that a model like this, which includes earnings levels and expectations, interest rates and actual stock prices is a ‘tried and true’ measure of valuation. The fact that it is at such a deep discount is simply a reflection of the negative sentiment around stocks and the pessimistic view of the outlook for global growth. To put this in perspective though, just reaching the bottom end of the valuation range would take stocks 25% higher than where they are trading right now! More importantly, if economic growth continues and earnings expand further, the gray band will move further ‘up and to the right.’ Stocks could stage a strong return just by moving back to fair value.
Although many investors and analysts are worrying about the upcoming 2nd quarter earnings reporting period, the recent data show that the outlook is not nearly as negative as many expect. While some early ‘high profile’ warnings have come from FedEx, Proctor & Gamble, Texas Instruments and Bed, Bath & Beyond, most of these downgrades have just been to the lower end of the prior range as opposed to radical cuts. We expect that profit growth will remain positive in the quarter and that annualized S&P500 earnings will come in around $100, putting the stock market at an exceptionally cheap earnings multiple of about 13 times. The chart below shows the BAML Earnings Revision Ratio chart, which is basically just the ratio of stock upgrades/downgrades over the last one and three-month periods. The chart clearly shows an ‘up-reversal’ in this indicator recently. This might seem counter-intuitive given that economic growth numbers have been downgraded recently and many analysts are uncertain about the outlook, but most of this bad news appears to already be factored into current earnings estimates. The negative outlook has definitely been reflected in stock prices, which have been falling over the past four months and are down substantially in the past year. If this reversal in the indicator holds, then we can also expect that to be another future ‘tailwind’ for stocks as the lows in this indicator in the past have also coincided with major lows in the stock market (chart shows how this indicator hit its prior low near the stock market bottom in March of 2009; prior to that it coincided with the beginning of the bull market that started in 2003).
