While forecasting the market’s behaviour for the year ahead is a mug’s game, some good reasons are emerging for thinking that the recovery in the equity markets could have further to run in 2010. My most recent column in the Financial Times picks up on this theme, with reference to a recent visit to London by Bill Miller of Legg Mason. The key point to note is that while many pundits are now belatedly talking bullish (normally a worrying sign), investors collectively are still not acting that way. Of course it will turn when the bond market finally seizes up, as all bets will then be off. In my view, however,despite the sudden strength of the dollar, we are not at that point yet. There is bound to be an early correction in 2010, but the year as a whole could easily accomnmodate a further 10%-15% rise.
A few years ago it was standing room only at the Savoy Hotel when Bill Miller, the celebrated manager of the Legg Mason Value Trust, came to London to impart his latest views on the market. While on his way to 15 successive years of outperforming the S&P 500 index, a feat that no other US fund manager has achieved in modern times, his fund rode a wave of popularity. As is the way, Miller’s every word on the markets was assured of a reverent hearing.
Last week, with the Savoy still out of action, Mr Miller made an altogether quieter appearance at the London Stock Exchange. Having misjudged the credit crunch, and seen his fund languish at the bottom of the performance league tables for many months, it was perhaps no surprise that only a handful of media turned up to listen to what he had to say.
Being both bullish about the equity market and happily out of step with majority opinion, Mr Miller’s views will struggle to gain traction for a while yet. At one point he compared the equity markets today with 1982, the year that the great bull market of the late twentieth century began. His point was not that the market conditions were identical at the time, but that if you looked at what analysts were saying about prospects in 1983, the list of potential negatives would have been as long and sounded just as horrible as that which prevails today.
Could the analysts be just as wrong this time round? Being out of favour is no obstacle to being right. Indeed it is a badge of honour for the contrarian investor. Having earlier drawn attention to his fund’s troubles in this column, I feel it only fair to report that Mr Miller’s fund has outperformed the S&P index by 10% to date this year, reversing some at least of the losses of his annus horribilis in 2008. What is more, I am beginning to suspect that his judgment on equity markets, which proved to be so wrong during the crisis, will be proved to be right now that it is receding.
What are the arguments for thinking that the outlook for the equity markets is much better than the prevailing consensus? Reading across from valuation measures such as Tobin’s q and cyclically adjusted p/es, the market currently appears to be trading somewhat above fair value. If you take them at face value, estimates for the earnings of the S&P 500 in relation to the market’s level look unexciting.
But how good are those earnings estimates? Estimates are poor at the best of times, and particularly unreliable at turning points. Just as it took a long time for analysts to catch up with the scale of the decline in earnings in the immediate aftermath of the crisis, so too they have been slow to catch up with the improving trend since the recession ended earlier this year. In the second quarter of 2009, more than 75% of companies in the US came in with earnings that were ahead of analyst expectations.
At the same time it looks in hindsight very much as if corporate America, in common with investors themselves, reacted too sharply to the post-Lehman global financial crisis. The scramble to cut jobs, slash inventories and reduce debt has left many companies struggling to fill orders as demand starts to return. (Tim Bond of Barclays Capital makes a similar argument, pointing out that delivery times are currently lengthening, not shortening).
Another metric that Mr Miller points to is the ratio of expected earnings growth to GDP growth, which at around eleven times a “new normal” GDP growth estimate for 2010 of 2.4% is well above its historical average of six times. Yet he is of the school that believes that the scale of recovery in the US economy after recessions is typically proportionate to the severity of the preceding decline in output. As the US recession has been the worst since the 1930s, the scale and speed of the recovery is more likely to surprise on the upside than the downside.
If the historical analogy turns out to be correct, the implication is either that current earnings expectations are too high, or that GDP projections are too low. Mr Miller’s money is firmly on the latter. He expects technology, financials and consumer stocks to lead the stock market higher in 2010. IBM, he points out, has 100 years of earnings data, and is well known for the reliability of its earnings guidance. It is looking to continue growing its earnings at an annualised rate of 15% through next year. Yet its shares trade at a discount to the market, at a lowly 11x earnings.
The reality is that the future direction of financial markets is never a one-way, predetermined street. In a year’s time, if Mr Miller turns out to be right about the scale of the recovery in the economy and equity markets, as I suspect he may, those who have been left behind will surely conclude that they have allowed their judgment to have been impaired for too long by the lingering trauma of last year’s crisis. To put it another way, given a choice between betting that analysts’ forecasts are precisely right or that investor psychology is roughly wrong, the smart money rarely errs by choosing the latter.
Jonathan Davis 