On Friday we published a piece called 'Recession - Now Priced as the Central Scenario' showing how the market was now discounting a 30% fall in profits next year based on a 4% ERP. Following the European Government initiatives that evolved over the weekend, we published the attached Strategy Matters looking at 10 reasons why the markets should enjoy a strong rally, although not yet a sustained bull market. We have also upgraded our weighting on the banks sector to neutral having been underweight for more than a year. The main points are:
Markets are unlikely to see a decisive transition to a new bull market until mid-2009, in our view. Valuations are attractive, implying a 30% fall in earnings in 2009, but that alone may not be enough; an inflection point in economic activity remains too far away. That said, many indicators point to a strong rally in equities. We give 10 reasons why we believe the market should now bounce:
1) Bear bounce
Bear markets do not tend to move in a straight line. Indeed, since July 2007, the DJ Stoxx has fallen over 40% but there have been seven rallies of at least 5%. Two of those rallies saw the market bounce roughly 8% and another two between 10% and 15%.
2) Risk aversion and valuation at extremes
Our risk indicator which is made up of 11 'risk factors' is back to 2002 levels. Valuations have reached levels which imply a 30% fall in profits in 2009, even applying an historically high 4% risk premia assumption.
3) Recession obsession
A barrage of recent indicators show that most of the Developed World is stagnating or in recession. Most of these indicators are at levels that are normally consistent with a recovery in risky assets relative to bonds.
4) Aggressive interventions
Central banks and governments are getting more aggressive and ever more proactive in targeting the banks and money markets. Many of the recent steps taken are, we feel, very constructive and should contribute to a market rally. We have upgraded the bank sector to a neutral, having been underweight for over a year.
