Who needs a boom anyway?

Equity investors – not least in Europe – saw the jubilant mood of the new year slide quickly toward hangover. The earnings season provided a sober and mixed assessment of economic conditions at the grass-roots level, puncturing the optimism of early January. Profit warnings continued to be a hazard for investors, with the negative surprises spread across a wide variety of sectors and styles. A meltdown in a variety of developing market currencies took its final toll on sentiment and confidence crumbled into February.

While the MSCI World index had been rising steadily since mid-June 2012, the increased confidence exhibited by investors was not matched by corporate profits, which remained broadly flat in that period. For the eurozone, flat would have been a good outcome as profits there fell at the same time that enthusiasm for all things peripheral rose. Inevitably, this left stock prices discounting an ever stronger recovery in corporate profits as the index level rose. The end of recession was not an automatic cue for a surge in profit growth, and this continues to be reflected in statements from companies that demand has either stabilized or shown modest increases; no one is talking about a boom in sales.

As the first chart shows, the rise in investor confidence – as illustrated by plummeting two-year Italian government bond yields – has led to a steady expansion in the price-earnings multiple of the European market since the dark days of 2011. In essence, the market has been revalued upward entirely by a decline in the risk premium, with no contribution from profit growth. With so much anticipated already, a period of correction and consolidation was inevitable to allow corporate earnings to catch up with share prices. With the U.S. starting to wind back the pace of quantitative easing, some of the rocket fuel propelling markets higher was being lost and a correction was both necessary and likely.

Low levels of volatility always lull investors into a false sense of security. At the start of January, the VIX index was back at 12.1, a level that was typical way back in 2007; in late November, the German version of VIX – VDAX - actually hit its lowest level since 2005. In early February, these indexes had spiked up to 21.4 and 19.5, respectively. As volatility itself is volatile, a low reading should act as a warning against complacency. That said, we should not forget that increased volatility is not a bad thing per se, as it is the price we pay for investing in long-term assets that are constantly marked to market. Falling stock prices and rising volatility suggest a better balance between fear and greed has returned to markets.

The uncertainty that the unwinding of U.S. quantitative easing creates is coinciding with an earnings reporting season that is challenging the elevated level of implicit corporate profits growth now discounted in markets. The transmission mechanism of rising levels of QE benefited developing markets and currencies and various “carry trades” for a number of years, so the decelerating pace of the stimulus is inevitably going to cause a few perturbations. The global nature of European companies inevitably exposes some of them to the weakness in emerging market currencies and lower sales growth in these countries. Many of these companies, however, have local sales matched with local production, so the impact on profit will not be as severe as many fear. After more than two years of underperformance by the MSCI Emerging Markets index against the World index, it could be that we are at the height of concerns on the developing stock markets and that some time a contrarian stance might be warranted on exposure to these economies.

A few modest falls in the index and the return of a bit of fear in the minds of investors is a healthy thing: it focuses attention back onto the financial merits of individual companies rather than the quest for pure top-down factor exposure and naked risk taking. The earnings cycle might have been tepid so far, but looking forward we should see earnings momentum start to accelerate in Europe, even if it is driven initially by the base effect of easy comparisons with previous years.

How long and how far the current correction will go is hard to judge but, given the diminishing number of attractively priced companies, lower stock prices and greater uncertainty are to be welcomed. Valuations had returned to near pre-crisis levels and this was not only for quality names, many of which have actually derated recently as investors have chased recovery names ever higher. A hiatus, therefore, is needed to allow value to return and for uncertainty to create a larger number of exploitable market inefficiencies. In an environment of limited value, earnings momentum and the ability to deliver positive surprises for investors, along with sales and profit growth are increasingly the differentiating characteristics of successful stocks.

The message from the corporate coal face remains mildly constructive: economic conditions have stabilized and are improving slowly, confidence is strengthening, but things certainly are not booming. But who needs a boom anyway? They tend to be followed by busts, so a nervous recovery based on improved corporate competitiveness and gradually improving investment is preferable to liquidity led euphoria. A bit of fear and uncertainty helps return value and inefficiencies to the market – exactly the conditions that stockpickers relish.

Andrew Parry is CEO of Hermes Sourcecap, London.