Right now, markets seem to be panicking about the always-scary “unknown” risks, like a full-on collapse in Europe and the subsequent infection of the banking system.
In the latest Global Equity Strategist note, Citi’s Robert Buckland looks at the prospects of a corporate profits recession, and what that would mean for stocks.
First, the argument starts with this chart, which basically argues that after a 20% collapse in stocks, we’re basically due for either another 20% collapse or a 20% rebound.
Buckland’s argument is that another collapse will likely only come if corporate profits collapse and that that still seems unlikely based on Citi’s proprietary earnings forecasting model.
For each region we find indicators that have previously led a profits collapse. We use these to build an index to help us predict a profits recession. Then we aggregate each regional model into a global index. We detail our model in the appendix.
We purposely do not use indicators that we think are less relevant now. So we resist using one of the best forward indicators of previous economic and profits recessions — an inverted yield curve. Fed Chairman Bernanke’s recent commitment to negligible US rates through to 2013 means that global yield curves seem unlikely to invert for some time. Historically this has provided reassurance that a profit collapse is not imminent. But we understand that this time it may be different. For example, the shape of the yield curve has not been an especially useful predictor of the profit outlook in deflationary Japan. To avoid those ‘but what if this is Japan?’ issues and make the model relevant now, we leave out the yield curve. Also, substantial current manipulation of government bond markets means that we feel uncomfortable interpreting what yields may be saying about the global profits outlook.
For similar reasons we also leave out interest rates. Again, high and rising real policy rates, especially in Europe and the US, have been helpful forward indicators of a slowdown. However, they have not been helpful indicators in deflationary Japan.
Anyway, the good news is that their model isn’t showing high risk right now:
While Citi doesn’t totally spell out its model, it does give some ideas:
What indicators do make it into our model? We employ a mix of micro and macro indicators that have previously provided the best lead on previous profits collapses. Some of our factors are specific to a given region. For example, in Asia ex Japan we found high real exchange rates have been successful in forecasting previous periods of earnings weakness. Similarly, in Japan, defensive stocks tend to surge ahead of cyclicals before EPS begin a serious decline. Importantly, we do not rely on one single factor. However, we do weight them based on how efficiently they have worked in the past. For example, unsustainably high RoEs (significantly higher than the previous cycle average) have been good predictors of previous earnings recessions in all regions, in pre-empting a profits collapse. Accordingly, this has a high weight in our model. By comparison, the oil price has been less effective in forecasting earnings downturns — it has provided many false signals in the past. As such it gets a lower weight.