It is well known that analysts’ profits forecasts start out over-optimistic and decline throughout the year. But we do not think this phenomenon is being given sufficient attention – 2015 was the worst year for earnings revisions since 2007, Exhibit 1. One could have been forgiven for thinking that a recession was on its way given the pace of the declines.
The harsh reality, even for an index supposedly exposed to the growth in the UK’s domestic economy such as the FTSE250, is that all of the gains in this index during 2015 represented P/E multiple expansion. Profits for the index remain stubbornly unchanged since 2013. As a result, the FTSE250 is currently trading at one of its highest forward P/E multiples of 18.5 in the last 15 years, Exhibit 2.
It is also unusually easy to provide a narrative as to why 2016 has started out with the same volatile trading conditions as at the end of last year. First, US monetary policy has become significantly less investor-friendly. Fed Vice-Chairman Fischer’s comments today confirmed that the US Federal Reserve’s view of the US economy remains more upbeat than that of market participants, thus implying a hawkish bias relative to market-implied forward interest rates. Investors perceive limited central bank ‘put’ protection in these circumstances, even if it remains our view that the Fed will change course in the event of either a major equity market sell-off or a shortfall in economic activity.
Second, with exceptionally weak earnings momentum a global phenomenon, developed equity markets are just not growing into their currently above-average valuations.
Finally, from a sector earnings perspective, the impact of the weakness in the global outlook and China in particular could not be clearer. Basic industry earnings forecasts fell by 50% during 2015 and still do not show any sign of recovery. In the energy sector, the second leg down in energy prices is still feeding into estimates, Exhibit 3.
In terms of share prices there can be tug-of-war between valuation and earnings momentum. When earnings momentum is strong, expensive sectors or shares may become increasingly expensive even as the longer-term expected return falls well below that considered adequate for the risks.
On the other hand, when earnings momentum is weak, entire sectors can become embroiled in a downward spiral as capital flees the sector as assumptions in respect of medium-term profitability trends are drawn into question. In troubled sectors, new management often consider it a good time to release bad news, adding to the pressure on share prices.
For example in the most recent decade it has been the mining sector which started the period over-owned, over-valued and over-investing – and which has since gone into reverse.
However at some point in the tug-of-war, near-term earnings forecasts become less relevant as asset values come into focus. The mining sector is now arguably as cheap as it has ever been on a price/book basis, Exhibit 4, as investors fear the uncertainty over the outlook for China. It has also been long forgotten that at least initially the declines in the iron ore price were the direct result of the larger, lower-cost miners’ strategy of squeezing out high cost competition, not unlike the actions of Saudi Arabia in the oil market.
Taking a medium-term perspective based on what are now heavily discounted valuations based on the recent flood of downgrades, in our view the time to exit the sector has passed, even if the downturn is proving significantly longer and deeper than we initially expected.
The correlation between UK earnings revisions and UK sector performance was exceptionally high last year at 70% as investors are focusing ever more on the sustainability of profits and profits growth.
It seems only logical to us that as median valuations remain elevated, developed market equities will continue to move sideways until earnings forecasts at least stabilise and investors regain confidence in the most fundamental reason – a share of a growing profits stream – to own equities in the first place.