Why We're Still Underweight Equities (Just Less-So) - III

Equity markets' rally in the past month seems to reflect diminished fear of a financial system collapse (which we agree with, for now), but also shows little concern for the pending significant pressure we expect to see on corporate profits, fallout from the continuing credit crisis.

We articulated this view more fully in our post here.

A short FT article today summarizing the opinion of a Morgan Stanley strategist puts some additional figures on essentially the same view as ours:

• The bear market rally in European equities is over and corporate earnings over the coming year are likely to fall well short of expectations, says Teun Draaisma, strategist at Morgan Stanley.

  He points out that the MSCI Europe index has risen 11 per cent since hitting a trough on March 17, and believes there is limited further upside to the current rally.

  “We expected a bear market rally of at least 10 per cent on the back of a drastic policy reaction to the problems at hand,” he says.

  “Most policy action has been taken or is fully expected, while our all-important market timing indicators have given us the warning that the rally is over.”

  Mr Draaisma says inflation in Europe has been surprisingly strong, and that there have been tentative signs of the earnings downturn spreading beyond financials. He adds that money market stresses have not healed.

  “The biggest certainty for the next 12 months is that there will be a big earnings miss, as margins are at all-time high levels while top-line growth is slowing and costs are rising, and expectations are too high.

  “We forecast a 16 per cent fall in European earnings in 2008. Consensus earnings expectations have been cut 6 per cent so far this year but still imply 6 per cent growth, which is unrealistic.

  “The ‘financial end of the world’ has been avoided, but that still leaves us with a big earnings recession.”

To raise our equity allocations somewhat during the pullback of the past week, we've focused on the major trend toward investing for environmental sustainability, particularly companies we see as less vulnerable in the economic slowdown we expect to continue into 2009. (We've noted some of those companies under our Corporations subject link.) We'll continue to do so in the coming weeks, but with even greater selectivity after the equity markets' recent run run.