Forex Go!

Forward PE levels are at their lowest and expected earnings (implied earnings) at their highest  since the economic recovery started in early 2009. So, are these low vauations a value trap and should investors question the economic recovery?   

Low valuations, but it’s not so simple…

In chart 1, we note a long downward trend in forward valuations in the STOXX 600 starting from 1999, showing how investors are more cautious when paying for future earnings. We also note that from 2003 to late 2008 there was an intense increase in expected earnings showing the optimism in the global economy at that time. During this period the forward PE stayed relatively constant as stock prices increased along with expected earnings. Once the optimism faded, valuations (and stock prices) decreased ahead of future expected earnings, taking most investors and analysts by surprise. When valuations hit rock bottom the market started seeing value and stock prices rebounded ahead of upward earnings revisions. This last point helps to show that analyst forecasts tend to change quite rapidly after an inflection point, but still lag stock performance - especially worrying since the market does not know if we are presently at an inflection point. Inflection point approaching!

Interestingly, if we overlay the above with the trailing P/E (essentially present market valuation), chart 2 illustrates that when trailing and forward P/E converge, expected earnings tend to be revised downward (inflection point). This presents a difficult period as earnings and valuations both decrease leading to a potential value trap for investors. These lagging earnings revisions then lead to P/E expansion and, voilà, the market is no longer a bargain. Presently, we see that implied earnings have not begun to head south whilst a convergence in trailing and leading P/E is occurring.

In chart 3, we can see that the number of estimate revisions have been decreasing since late 2010 and on a percentage basis have plummeted in the past 3 months, highlighting that analysts have not been revising their numbers, up or down. Analysts are either getting more accurate and certain of their numbers (unlikely) or they simply do not know what will happen to earnings and are waiting, just like the rest of us, to see where the economy is heading. Again, this is a worrying sign of a possible shift in outlook to the downside.

The European equity market is not a clear buy given the current expected earnings levels for the next 12 months. And slowing economic growth and uncertainty regarding the well-being of states and the financial sector do not appear reflected in forward earnings for the next 12 months leaving investors cautious in the near-term.

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