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P/E exercises

Aweak economic background is now widely regarded as a given but there is much less consensus about whether stocks are a buy or a sell at current levels. On the face of it, simple valuation data sends a clear signal that stocks are cheap. For example, according to MSCI data at the end of January, the trailing price/earnings ratio for the MSCI UK index is 11.2, which is well below its average of 13.4 since 1969. Similarly, the historic dividend yield is 3.7 per cent, which compares very favourably with the current 4.5 per cent yield on 10-year gilts.

By and large, it is this simple analysis of valuations that forms the bedrock for the bull case on stocks but the bears take the view that there is a lot more negative news to come and that corporate earnings’ forecasts have much further to fall as the pain spreads from the banking sector to other parts of the economy.

UK corporate earnings are around 20 per cent above their long-term trend from 1969, so we are probably due a setback in profit growth and a degree of weakness should not be a surprise. We will only know for sure how weak the economy will be, and what impact this will have on profit growth, as we work through the coming quarters. What kind of economic scenario is the market pricing in?

Looking at historic earnings’ peaks and troughs, we have calculated that UK corporate profits fell by 35 per cent in the mid-1970s recession, 31 per cent in the early 1980s,35 per cent in the early 1990s and 16 per cent in the economic slowdown between 2000 and 2003. In assessing what kind of outcome is already priced into the market, let us assume a couple of scenarios. The first is a sharp slowdown/mild recession and the second is a nasty recession. In a sharp slowdown/mild recession, history suggests that corporate earnings could be knocked down by up to 20 per cent. If that was to happen, the market p/e of 11.2 would become 14 as it adjusted to a lower earnings’ level. In a nasty recession, earnings would fall by 35 per cent and the market p/e would adjust to 17.2.

A market p/e of 14 is pretty much in line with the long-run average of 13.4 and is in the vicinity of what we would regard as a fair and reasonable mid-cyclical stockmarket valuation. We believe the market is already pricing in the first scenario – a sharp slowdown/mild recession. This outcome is quite a lot worse than most economists and analysts are forecasting but that does not mean it cannot happen. Even so, we believe that any investor with a longer-term horizon who is selling at today’s valuations is betting on an even worse outcome, namely, that we are heading for a hard landing – something we do not envisage and which is certainly not in the price.

Andrew Yeadon is head of multi-manager at Schroders

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