Trygve Tøraasen, fund manager of the Thames River Capital European fund, explains why investors do not trust earnings forecasts.
By several measures, equity markets appear to be cheap. Dividend yields are higher than treasury yields, a situation that has historically been a strong buy signal for equities and yet markets have been drifting without much direction for a while, which indicates investors have little faith in current earnings forecasts.
The consensus outlook for economic activity and, by extension corporate earnings, has seemingly deteriorated over the last few weeks. Several leading indicators have seen a weakening in the magnitude of positive readings and talks of a double-dip recession have resurfaced. However, recent corporate earnings reports have been strong and outlook statements have been largely positive.
When we talk to corporate managements we generally receive cautiously optimistic feedback. So how do we explain this disconnect? It is of course possible there is a lag in the reporting chain of the corporate world and that the feedback we receive is based on conditions that existed several months ago. Another possibility is that investors and commentators are guilty of blindly extrapolating the trajectory of growth data and therefore focus more on the second derivative of the growth number rather than the absolute growth number itself.
The likely explanation is somewhere in between. After a dramatic slowdown in activity between June 2008 and June 2009, there was an equally dramatic recovery. This was to be expected as businesses had run down inventories and as soon as they saw some indication of improvement they started to rebuild them. At the same time, stimulus driven activity created further demand.
However, this snap-back has now largely played out and leading indicators are probably starting to reflect a true underlying level of activity. We think this will be sluggish for some time as previous excesses are still working their way out of the system. It was always unlikely that there would be a sharp V-shaped recovery where the previous levels of growth would be achieved quickly.
We are faced with several years of government cutbacks and further consolidation of household balance sheets which will put a dampener on activity. Activity is also being stimulated through historically low interest rates and it is difficult to say that we are back to an average level of activity before interest rates have returned to a more normalised level.
However, it is not all doom and gloom. There are a number of companies doing very well and seeing improving prospects and we are focusing on these companies.
Trygve Tøraasen is fund manager of the Thames River Capital European fund
