15th July 2022
We try to buy assets when they are cheap and tend not to worry about timing the market. However, cheap assets can get cheaper. With regards to equities, if current earnings estimates are too high – because a recession is upon us, then there Is a danger of being too bullish on valuation.
With this in mind, Absolute Strategy Research, an independent research organisation run by Ian Harnett and David Bowers, whose excellent output we pay for, yesterday wrote on the very subject of whether equity markets are currently pricing in downside in earnings estimates given most investors believe we are in or headed for a recession. Their view is that EPS (earnings per share) could fall 10-15% YoY vs the consensus of 9% growth. They also identify that equities tend to turn prior to the trough in EPS. They estimate this occurs about 9 months before the trough in earnings, which is 8 months after the end of the recession. Equities have already fallen a long way, and their best guess is that prices have now discounted an 8-10% decline in earnings. Should earnings fall further, there is clearly more downside – especially given their observation (one that we continually point to as well) that the starting point for this bear market was elevated earnings (thanks to very high profit margins – which tend to be cyclical) and elevated valuations too. Another observation they make is that in the 3 previous recessions, analysts forecasts were out by 33%, 46% and 25% – suggesting ASR’s own forecasts might be too optimistic. In addition, equity prices tend to end recessions “below trend” – i.e. overly cheap and discounting too pessimistic an outcome. This is something else we constantly repeat: in bull markets valuations overshoot to the upside and in bear markets they overshoot to the downside.
This is useful research to have at our disposal. It suggests we could easily have more downside in equities despite the fact that they are arguably already pricing some earnings falls. But the fact is no-one will know when the bottom is in until after the event, and no one has any edge in knowing when that might be ahead of time.
Instead, we are happy that we can invest in actively-managed equity portfolios whose managers are saying that their stocks are at “career-level” low valuations. But we also know from ASR that at the aggregate level, the balance of probabilities suggests more downside as we head into a recession (indeed, one probably started in Jan/February this year – recessions are only known after the event due to the complexities of gathering data). This means that we are right to be allocating more to our favoured equities managers but that we should leave plenty of room to further increase allocations.
This conclusion is mirrored in our approach to fixed income. With regards to credit, high yield spreads are around 600 basis points. They typically peak at around 1000bps in recessions (and spend very little time that wide). Crudely this suggests credit markets are pricing in 60% of a recession. Actively managed credit portfolios are generating much more spread than this (close to absolute yields of 10% even for a predominantly investment grade portfolio and 12% for high yield). So again, we are right to increase allocations here, but leave plenty of room to add if spreads get wider.
We believe that over a 3-year holding period, owning plain vanilla equity and fixed income portfolios should generate respectable positive real returns. This is the first time we’ve felt confident in saying this for many years. Rather than definitively state that equities or bonds have fully priced in a recession that we may or may not be in, we’d rather worry about returns over at least a 3-year period. We’ll stay within our circle of competence – buying assets and funds with an adequate margin of safety and not worry about trying to time the exact point in time that equities have priced in the precise fall in earnings that will result from a recession.
Ben Conway – Head of Fund Management
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