COMMENT: The twilight zone - a playbook

By bne IntelliNews May 4, 2009

Robert Buckland of Citigroup Global Markets -

Twilight Zone - This is the phase in a global earnings recession where share prices start to rise despite further falls in corporate earnings. The beginning of the Twilight Zone is associated with sector rotation out of defensives into cyclicals.

This Could Be It - The latest equity market rebound has occurred against a backdrop of cheap valuations, stabilising lead economic indicators and tightening credit spreads. All have been associated with previous Twilight Zones.

Market Strategy: More To Go For - The recent 25% rebound in global equities represents the fastest ever start to a Twilight Zone and suggests that some consolidation may be appropriate. However, an average performance of 45% through previous global Twilight Zones suggests that investors should buy equities into any weakness

Sector Strategy: Don't Chase It - Recent rotation towards cyclical sectors is already as large as seen in other Twilight Zones. This suggests that it may already be too late to make the switch.

Last November, we suggested that global equities were set to enter the "Twilight Zone". This is the period towards the end of a slowdown when earnings are still falling but share prices stabilise. In effect, equity indices get so cheap that they discount further falls in profits and are even able to start looking towards an eventual recovery. We suspect that global equities are now back in the Twilight Zone - strategists around the world generally agree that March marked the low for this bear market.

The Twilight Zone is full of contradictions. On one hand, falling company earnings suggest continued caution. On the other hand, better equity markets suggest a more aggressive strategy is appropriate. Here we provide some further guidance on appropriate strategies for these confusing times.

Global Twilight Zones

Figure 1 shows the MSCI World price and earnings indices over the past 40 years. We use trailing earnings, so there will be some reporting lag. This chart confirms that over the long run, share prices track corporate profits, but they can diverge in the short term. And of particular interest to us right now, there are four periods when share prices are rising despite earnings falling.

The first occurred between October 1974 and January 1976, where global equities rose by 54% despite earnings falling by 28%. Presumably, this was because global equities had already halved before earnings rolled over. By the time the downturn started, it was already discounted in valuations.

The next Twilight Zone occurred in the early 1980s recession. Between August 1982 and May 1983, global equities rose by 49% despite earnings falling by 2%. This was more conventional than the mid-1970s experience. Equities were weak in the first part of the recession, but turned 10 months before corporate earnings.

The early 1990s saw the longest Twilight Zone. Global equities bottomed in October 1990, a full 33 months before the turn in the earnings cycle. Concerns around the Gulf War drove share prices down sharply in 1990, which provided a low base for global equities to make decent progress even against a prolonged earnings downturn.

The late 1990s saw a short Twilight Zone associated with the Asian Crisis. Earnings fell by 9%. Over the same period, global share prices rose by 40%. This will have been a particularly confusing period in Asian equity markets where earnings were collapsing, but continued strength in US and European equity markets dragged indices higher.

Figure 1 also shows that while most recessions do have a Twilight Zone, it is not always the case. For example, we saw a 38% contraction in global earnings at the start of the present decade. But share prices were not able to stabilise until earnings had stabilised. There was no Twilight Zone here.

Why a Twilight Zone?

This raises an obvious question: What makes us confident that we will even see a Twilight Zone in this cycle, let alone that we are in one now? Given that we expect global earnings to fall by another 30% over the next 12 months, why shouldn't equities make new lows?

If the Twilight Zone begins at the moment that share prices have fallen far enough to discount the ongoing earnings collapse, then we would expect cheap valuations to be present. Figure 3 overlays the global Twilight Zones on the MSCI World trailing P/E. Figure 4 does the same for price/book value.

The MSCI trailing P/E hit a low of 9x back in March. This is well below the levels reached at the beginning of the two 1990s Twilight Zones and consistent with the early 1980s. Only the 1970s was lower at 7x. And perhaps this helps to explain why we never saw a Twilight Zone in the last earnings downturn - valuations never got cheap enough.

Of course, it is questionable to use trailing multiples when there is such uncertainty about earnings. However, that is always the case in the Twilight Zone. There is a sharp re-rating - falling earnings and rising prices mean that the market always exits the Twilight Zone on a significantly higher P/E than it enters. And if we assume that global earnings have another 30% to fall from here, then at current share prices that would assume an exit multiple of 18x - higher than the mid-1970s or early 1980s (both 13x) but well below the early 1990s (22x) or late 1990s (34x).

Perhaps we should look at more stable valuation metrics at times when the earnings outlook seems so unclear. P/BV valuations, a favourite of Markus Rosgen, our Asia-Pacific strategist, strip out much of the cyclicality displayed by a trailing earnings index. Figure 4 shows P/BV valuations for the MSCI World index. The recent 1.3x low is again well below the Twilight Zone entry points of the 1990s but still above the 1.0x troughs seen in the 1970s and 1980s. Nevertheless, the severe de-rating beforehand is compatible with previous experience.

Lead indicators

Another characteristic of previous Twilight Zones is improving macro lead indicators. Figure 5 shows the US ISM index. A turn in this key lead indicator seems to be a key characteristic of all previous Twilight Zones. This helps to improve investor risk appetites even though contemporary profitability suggests continued caution. It helps share prices decouple from falling earnings.

Figure 6 gives a global perspective. The OECD composite leading indicator looks at a wide range of global data series (including the ISM) that have historically given a decent lead on the global economy and corporate earnings. Again, it tends to be recovering from a very low point during the Twilight Zone. One notable exception is the double dip of the early 1990s, but at least the OECD CLI did not make significant new lows.

So it does seem that macro green shoots are characteristic of the Twilight Zone. Global equity indices choose to follow these signals rather than dwelling too much on continued misery in the corporate sector. Stocks are less sensitive to bad news. Company analysts write research notes suggesting that they can see little fundamental justification for the rebound in cyclical company share prices. Sound familiar? Currently, there are some green shoots that have encouraged investors to look through poor corporate newsflow. The ISM has stabilised, although at very low levels. We would expect the OECD CLI to do the same soon. For a more detailed discussion of global green shoots please see a recent Global Equity Strategist2.

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