Some positive surprises

May 7 2008 by Andrew Miller, The Journal

OVER the past few months, there has been a shift in economic data. Rather than one disappointment after another, we have seen more balanced news flow. More of the news from the US has been in line with expectations, and there have even been some positive data surprises.

At the same time, financial market conditions have improved substantially after the Federal Reserve took further action and financial institutions began to strengthen their balance sheets. On the back of these developments, there has been a substantial rebound in riskier asset classes, such as corporate credit and equities.

Some noise and market jitters are likely to follow such a rebound, but nevertheless we feel that the fundamental improvement in the market, the economy and equity valuations is strong enough to justify an increase in our allocation to riskier assets. Accordingly, we have closed our underweight in credit, and increased our overweight in equities from 5% to 7%.

The larger allocation to credit results from increasing our sector allocation in financials to neutral. Within equities, we have increased the allocation to US, emerging market and UK equities, with the largest increase in the US, where most of the work on restoring financial order has been done. We have maintained our overweight in European equities.

Following the recent cuts in earnings expectations and rising stock markets, US equities are now trading at a 12-month forward price-to-earnings (PE) ratio of just above 14 times, not far above the recent 12-year low.

As some critics will rightly point out, this does include an expectation of 14% growth in earnings per share over the next 12 months. However, even with no growth in aggregate earnings over the next 12 months, the market would still be trading on a 12-month forward PE below 16 times, with earnings just 7% below the peak of more than 18 months earlier. This hardly looks expensive, if the economy recovers in the manner we expect.

Moreover, our preferred bonds versus equities indicator currently gives a strong signal in favour of equities; even a substantial further correction in earnings and earnings expectations would leave this indicator well inside ‘buy’ territory. The same is true if US bond yields were to move back to more reasonable level (above 4%). As we see it, the risks surrounding equities relate not so much to whether a 12-month forward PE ratio looks attractive, but rather whether the US economy can avoid a serious slump. If a negative spiral along the lines of 1991 and 2001 is avoided, we would expect that US corporate earnings to decline by significantly less than the 19%-23% recorded in the two most recent recessions. As profits have already fallen by about 7%, it seems likely that we could soon be through the worst, in terms of earnings corrections.

Andrew Miller is regional office head of Barclays Wealth