Based on price-to-book valuations, Canadian equities looked historically cheap early this summer, and since then have become even cheaper. With return on equity holding up reasonably well for the market as a whole, this would appear to be an opportune time to take advantage of depressed valuations of selected stocks.
The median price to book (P/B) ratio has fallen to 1.17 times on Oct. 5 from 1.37 times in early June. The median P/B is now just 24% higher than its lowest level during the bear market crisis of 2008-09. And it has almost reached the lowest level of the 1990-91 recession, which was 1.07 in November 1990. The recent level of 1.17 is largely attributable to the plunge in the energy sector. Excluding energy stocks, the median P/B of all other stocks is 1.34.
The biggest difference -- when comparing current stock-market valuations with those during the 1990-91 recession -- is that return on equity (ROE) net of T-bills currently remains at a healthy 3.6%. By comparison, ROE remained mired in negative territory between February 1989 and April 1993, and was -5.4% at its worst in October 1990.
For the current ROE to remain at an attractive level in relation to the median P/B, companies must continue to produce earnings. Analysts have cut their earnings estimates, though not drastically. The average three-month earnings estimate revision for stocks in Morningstar's CPMS universe was -8.3% at the end of September. By comparison, it was -24% in December 2008 and -24.8% in May 1991.
Another earnings metric that should be watched closely is median earnings-per-share growth (last quarter versus the same quarter one year ago). At last report, EPS growth is negative, at 1.1%. On the bright side, almost half of Canadian companies are increasing their earnings.
Furthermore, if the analyst estimates for the third quarter turn out to be true, the median will rise to 0%, meaning half of Canadian corporations will have positive earnings growth, and half negative. This should not be viewed as abnormal for the Canadian market, considering that every two or three years Canada experiences earnings growth of zero or lower. Moreover, the modest negative values for earnings growth are a far cry from the alarming -28.8% in September 1990 or -28.6% in May 1991. These months had the two worst earnings figures in 30 years.
As for comparisons with the valuations during 2008-09, circumstances were far different back then because of the U.S. credit crisis that affected markets around the world. The Canadian economy was doing well and net ROE stayed high. And, while the median P/B plunged in 2008, it recovered very quickly. From a multiple of 0.94 times in November 2008, it rebounded to 1.56 a year later in November 2009. When the P/B was practically at its lowest (0.97 in December 2008), the ROE was at its peak level (6.4%) of the last 30 years.
Based on the experience of the 1990-1991 recession, P/B valuations can take years to recover, depending on earnings trends. From 1.07 in November 1990, it took until May 1993 for the P/B to recover to 1.55, a level that is still fairly modest relative to normal in Canada. During that period, ROE reached its historic bottom of -5.4% in October 1990.
The Canadian market's recovery from the 1990-91 recession was hindered by a slowdown in the U.S. economy, and the subsequent recovery was export-driven. That's what could happen this time too since the weak loonie makes Canadian goods cheaper for foreign customers, and considering the current healthy state of the U.S. economy.
