Is it worth buying equities as we enter a recession?

Conor White writes that now might be the time to buy equities, as equity markets normally bottom as economies enter recession. The worst that could happen is that you just get your dividend yield.
It has been a ‘white-knuckle ride’ in financial markets over the last couple of months and we have seen a reset in market expectations. At last, financial markets have conceded that there will be a recession across the developed world and have moved asset markets to reflect that. In the past weeks, we have seen some recovery in share prices but it has been somewhat anaemic.

h4. Recession is arriving
In recent weeks, we also got a sample of what it is going to be like as we get recessionary readings from the economies. In the US, the industrial production fell 4.5 per cent year on year (YoY), which is recession territory. There was some short-term impact from the hurricanes and the Boeing strike. But even excluding this, production was down almost two per cent YoY. Retail sales growth slowed significantly, down to 1.6 per cent YoY, which is the level of retail sales consistent with recession.
In the UK, unemployment spiked up to 5.7 per cent, which is the highest level since the recession of 2000. The ZEW from Germany was back to a level not seen since the post-unification ‘bust’.
h4. Feeding through into the markets
For much of the last year, we had seen significant falls in financial share prices and some consumer-related sectors, but in other sectors, the falls in share prices had been modest enough. Equity markets recognised a problem with the financial system but had not factored this into a broader economic outlook.
This has changed over the last couple of months, as we have seen the greatest weakness in cyclical areas of markets across the globe and equity markets have moved to price in a recession and, in fact, nigh on depression conditions.
h4. Policy response
The Troubled Assets Relief Program (TARP), which is a plan for the United States Treasury to buy distressed debt from United States banks, has been passed. More and more European governments, including our own, have guaranteed the deposits of their respective banking systems.
We have also seen several European governments inject capital directly into some of their local banks. All of this has been followed by co-ordinated reductions in short-term interest rates by seven major central banks including the European Central Bank.
h4. Valuations adjusted
The Euro-Zone currently trades on an historic PE of 8.0x against the 20-year average of 14.6x. Hence for the multiple to get back to the 20 year average earnings would have to fall 57 per cent which would need depression conditions to be achieved. There is no doubt that profit forecasts are too high at the moment but the valuation on the market is already saying that.
The dividend yield is giving out the same message. The Euro-Zone equity market is now yielding 5.5 per cent a full 1.5 per cent above the ten-year Euro bond, which means that over the long run, dividends are going to decline. The current valuation is indicating that we are moving towards depression and that economies will not be able to self-adjust.
Enormous damage has been done to the financial system and this should have an impact on the real economy, but valuations would appear to have discounted this.
h4. Newsflow will be poor
Over the next number of months, the newsflow is going to be poor and there should be cuts to economic forecasts and as a result to earnings expectations. Unemployment will rise and consumption should slow. There is, and will continue to be, much discussion about the depth of the recession and the strength of any recovery.
There is most likely going to be continual reference to a broken financial system which will not lend and a consumer so indebted that he will not borrow, nor will he spend. But equity markets try to anticipate events.
Looking at the recessions in the United States and the United Kingdom in the early 1990s, which have many similarities to the current one, equity markets actually hit their low points just as the economies were moving into recession. This would suggest now is the time to start buying equities.
h4. Tougher this time
Now the point can be made that there are greater stresses and higher levels of indebtedness today than there was back in the early nineties and thus, the evolution of equity markets will be different. But the valuation is materially lower.
Heading into the recessions of the early nineties, the UK market was on a multiple of 12x as against its current 8.4x and the US was on a multiple of 13x as against the current 11.4x. This is despite bond yields being six points lower in the UK and five points lower in the US.
The last few weeks have been the most bruising in equity markets for quite a number of decades. If the prices are correct, then the world economy is unable to right itself in the normal one- to two-year time span.
If you believe that the economic system does have the flexibility to overcome its problems and fiscal and monetary policy will remain growth-oriented, then one would be buying equities now, as valuations are now discounting depression and equity markets normally bottom as we enter the recession.
The worst that could happen is that you just get your dividend yield, but even that is higher than a bond yield now.
* Conor White is a Senior Portfolio Manager with Goodbody Stockbrokers. He can be contacted on 01 6419295 or conor.p.white@goodbody.ie
* Goodbody Stockbrokers is the stockbroking arm of the AIB Group. Goodbody Stockbrokers is regulated by the Financial Regulator and is a member firm of the Irish Stock Exchange and the London Stock Exchange.
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