Thursday, 28 January 2016

Equities: a 2016 US (profit) recession is mostly priced in. It's happy days for value investors

The S&P500 ended 2015 with a 1% loss. And the largest performance dispersion since 1999 when the Internet bubble was about to peak: the top 10 performing S&P500 stocks (led by FANGs - Facebook, Amazon, Netflix, Google) gained around 23%, the other 490 index constituents lost, on average, 3.5%.

From its July 2015 peak to its (so far) 20th of January bottom, the S&P500 lost nearly 13%. If you exclude last year's 10 top performers, the loss amounts to 26%.

Since WWII, the S&P500 tends to fall, from peak to trough, by 1x-1.5x the underlying constituents percentage profit fall during a recession. This means that excluding the last year's 10 top performers, the S&P500 (let's call it the "S&P490") is currently pricing in a 17% to 26% profit recession for 2016 (note: a similar conclusion would be reached if we used the Russell 2000 index).

How does this compare to previous recessions? The following chart provides the answer:
With the exception of 2009's financial crisis there has been no case since WWII where US corporate profits declined by more than 25% during a recession. And in the vast majority of cases the decline was limited to less than 20%. So, even if a US recession were to take place in 2016 it is highly unlikely that the "S&P490" would fall by more than 5%-10% from its current level.

Similar conclusion can be reached by looking at Shiller's cyclical-adjusted PE (CAPE) for the S&P500:

It's current level is 24. The "S&P490" CAPE however is only 18 and a 10% correction would put it comfortably below the post-WWII average CAPE of 18.6.

Cutting a long story short: the 10 top performers in 2015 are distorting the valuation picture of the S&P500. Following the heavy correction since the July 2015 peak, finding US stock bargains is not an almost impossible task anymore (and the same applies to European equity markets). Quite the contrary. For value investors happy days lie ahead.

PS A China economic collapse and / or major devaluation of the renminbi would change my optimistic view for US and European equities. However, my view on China didn't change. A severe crisis may happen. But not in the next 2-3 years. Here is why. Again (note: the capital account seems to be more open / leaky than I thought but nothing that good old capital controls can't solve, if necessary): China: a remake of 2008's financial crisis?

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