Equity slump or just a pause?

Nov 11 2009 by Andrew Miller, The Journal

THE equity market rally ran out of steam in October, with the MSCI World index posting its first negative monthly return since February. To see markets hit by profit taking following the long and strong rally from March's lows perhaps comes as little surprise to many investors.

But now they must ask themselves whether this represents the start of a longer downtrend in markets or just a brief pause. While there are reasons to be concerned about the sustainability of the equity market rally, there are more reasons to be optimistic as far as we are concerned.

Following the circa 60% rally in equities since their lows in early March, it was perhaps inevitable that some commentators would become concerned that valuations may have run ahead of what is warranted by fundamentals.

To date, however, the recovery in equities has been well supported by a discernible improvement in economy activity; further evidence of this has emerged in the last couple of weeks, with, for example, third-quarter US GDP data showing that the world's largest economy had grown more strongly than economists had expected.

Encouragingly, this has happened without much of a contribution from inventories, and last week's purchasing managers' indices - an important measure of corporate and economic health - remained in expansionary territory for both the manufacturing and services sectors.

The ongoing recovery in the economy should continue to support corporate earnings, which in turn should support equity valuations. Indeed, even allowing for the c.60% rally since the dark days of early March, developed markets' price-to-earnings ratios are still only at their median trading range for the last ten-year period, which, given that we are still in the "recovery" phase for the economy, looks undemanding.

But what of the outlook for earnings from here? The third-quarter earnings season for the US provided much cheer for markets with significant "beats" from many of the blue-chip names. At the beginning of the earnings season, analysts were looking for earnings to fall by 25% year on year. As things currently stand, that number is now closer to 17%, a significantly better outcome than many had thought possible.

These better-than-expected earnings numbers have also been accompanied by signs that top-line revenues are recovering at some companies - another plus point for equities.

With the third-quarter behind them, analysts are now turning their attention to next year, and the news here is also turning more positive. There have been upgrades to analysts' earnings expectations for the third consecutive month, leaving estimates for earnings growth for the MSCI World next year at a healthy 26%, which translates into a price-to-earnings ratio of 14.3 times - which, by historical standards, is far from being expensive.

Over the next few months, we expect that earnings will continue to benefit from upgrades as analysts adjust their numbers to reflect the economic recovery.

With valuations undemanding, further earnings growth should provide equity markets with scope for further gains. This is one of the key reasons why we believe that October's setback in equity markets will prove temporary.

Andrew Miller is regional office head at Barclays Wealth in Newcastle