Building in Risk Premium – When Enough is Enough!

By Mike Lenhoff 14:01 30- Jan -2008

Is it likely that Marks & Spencer will never sell another pair of socks or underwear again - even if Jeremy Paxman won’t be a buyer?

Or that the house builders won’t ever build another house? Or that no one will ever bank with Royal Bank of Scotland again? I doubt it, yet that’s what the p/e ratios are telling us! The shares are cheap as, indeed, are many more. The equity market is still oversold, there’s value and US interest rates are plummeting. Soon they’ll be doing something similar, or nearly so, in the UK

The prospect of a US recession still hangs in the balance but equity markets think the credit crunch will tip that balance. Equity markets are not just pricing in a phase of weakening profitability, they are also building in more risk premium and behaving as if more bad debts lie in store for the banks along with more restrictive lending, more disappointment on earnings, job losses, more bad debts and so on and so forth.

This feedback loop, with its disinflationary, if not deflationary, tendency to induce the forces of economic contraction, was identified as a risk by the Fed. The way I see it, equity markets have been building in the risk premium to take account of the rising default risk implicit in this loop. However, in doing so, the question must surely be; when is enough, enough? That’s what’s pushing the p/e ratios down.

Equity markets are fearful that lower interest rates won’t do the trick but they will - in time! That’s not me saying so - it’s what the US Treasury market is saying. The yield curve is not only upward sloping but steepening, thus reflecting that monetary policy is easy, which it is rapidly becoming, and that an upswing in the cycle will come through eventually.

With all the bearishness around it is easy to forget that the non-financial corporate sector isn’t doing badly. According to Thomson Financial, earnings for the S&P 500 excluding financials is expected to come in at over 11 percent for the quarter now being reported. That’s plus 11, not minus 11 percent, and that’s after a lot of earnings downgrading in several non-financial sectors!

Bearish phases need to run their course and no amount of protesting over inexpensive shares will alter that. But the question to consider is whether a bull market is likely to end on the p/e ratio it started.

At the time of the Baghdad Bounce, the FTSE 100 traded on a forward p/e ratio of around 12. At the time the upward trend line shown in the chart was breached, the FTSE 100 also traded on a forward p/e ratio of around 12. Of course in the spring of 2003 earnings growth was accelerating on the back of the pick up in the cycle and consensus estimates for earnings were being revised up. Today, earnings growth is decelerating and the consensus estimates are being revised down.

Importantly though, earnings are still growing, US interest rates are coming down, which matters more than anything right now, shares are inexpensive and, in a good many cases, cheap, Marks & Spencer will no doubt continue to sell more socks and underwear, the house builders will no doubt build more houses and RBS will continue to attract the business. For the long term investor, this is a buying opportunity.