Outlook 2012 ( 515 KB )

 

  In the final days of 2011, four years after the subprime crisis broke out, the conditions under which financial markets are operating are once again looking sombre, especially in Europe. On the one hand, the macroeconomic environment is plagued with hazards and beset by uncertainty. The deleveraging process of numerous agents (be they households, banks or governments) is incomplete, so that there are many threats that could still lead to recession, in particular the debt crisis that's punishing the euro area. Unfortunately, the capacity to act of political and economic authorities is not inspiring enough confidence and the effects of the measures adopted and those that might be adopted are doubtful. On the other hand, and to a large extent as a result of this situation, investors' appetite for risk has decreased while their preference for liquidity has increased.

  In the stock market arena, performance in 2011 has been poor in the United States, bad in the emerging countries and very negative in the euro area, particularly in its financial sector. This has merely lengthened the prolonged period of stagnation and the high volatility experienced by the West's stock markets for several years now. The question is whether, as from the coming year, conditions will tend to improve and thereby boost share prices, or whether the opposite will happen and this downward slide will continue or even get worse.

  In the first instance, the key factors can be found in the world's macroeconomic trends, in the outcome of the European sovereign debt and banking system crises and, for Spain, in its ability to correct its budget and reform the economy. These issues are dealt with in more detail by other sections in this report.(1) However, we should point out here that, with the appropriate provisos, there's good reason to predict a moderately positive scenario on these three fronts, provided the political forces have enough sense, courage and technical know-how. If this is actually what happens throughout 2012, the implications will be favourable for the fundamental decisive factors underlying stock market prices: corporate earnings and the risk premium. Certainly, the contribution of both variables will be significant but, in the singular state of affairs today, with exceptionally high uncertainty, the latter has become particularly relevant.

  (1) See, in particular, the other three Boxes, which review the key elements for each of these issues.

  Investors' expectations for corporate earnings and dividends have fallen in the second half of 2011, due to the slowdown in the world's economy and the worsening of the European debt crisis. In fact, as can be seen in the graph below, this decline in expectations(2) has been particularly severe in the euro area, a circumstance attributable to the relative weight of the banking sector in its stock markets (almost 25% in the index selected). In fact, repeated messages that the region's banks need to improve their solvency, if necessary resorting to increasing their capital and curbing the payment of dividends, have been a vital element in this sharp change in prospects.

  In any case, the expectation of a level of dividends per share over the next four years that is around the same size as the figure fifteen years ago is unlikely to be called optimistic or inflated, unless we expect disaster for the euro project, the collapse of banks and a far-reaching and long recession. Insofar as a non-catastrophic scenario is expected for the euro area, earnings and dividends are likely to surprise us and exceed the figures expected by the markets. The situation is different for the United States, however, where investor expectations, although not exaggerated, are more generous and therefore more vulnerable to unexpected setbacks in the economic cycle.

  (2) The graph refers to futures contracts for dividends per share of the companies on the Index Eurostoxx 50, interpreting them as representative of investor expectations as a whole. Estimates by the consensus of professional analysts have also decreased but, in this case, from and to higher levels, given these agents' traditional tendency to overestimate, as well as their inertia.

  What should be noted is that this projection for the euro area assumes, at the index's current levels, a dividend yield in the order of 4%, a level in the upper range of those observed over the last few decades. Once again, the situation is different in the United States, as valuation there is much more demanding, offering only a moderate appeal. Other stock market valuation indicators also show the same for both regions, such as the cyclically adjusted Price/Earnings ratio (CAPE) and Tobin's q.

  The factor underlying the euro area's relatively high dividend yield is, presumably, a rise in the stock market risk premium.(3) This interpretation is in line with the information provided by other indicators, such as sentiment surveys on investors of all types, the level of risk premia for sovereign and corporate bonds, the volatility implicit in stock options, the high correlation between different assets, etc. On the other hand, various academic studies(4) have highlighted that, historically, increases in the dividend yield ratio have mostly been due to rises in the risk premium and, consequently, have generally led to a subsequent improvement in returns in the medium term (through dividend pay-outs and/or stock revaluations).

  Several theoretical explanations have been offered for the causes that increase or decrease the risk premium. Some are based on arguments that assume investors do not behave completely rationally but suffer from cognitive limitations in appreciating the fundamental value of assets, making them succumb to fads, panics(5) and other kinds of psychological bias.(6) Others uphold the paradigm of rationality and even the capacity of agents to appreciate fundamental value, but argue that investors lose their tolerance for risk when, at times of economic crisis and growing unemployment, they feel their income and consumption are threatened.(7) The risk premium has also been related conceptually with the existence of financial frictions (such as liquidity crises) and with imperfect information. Whatever the case, the situation currently being experienced by the euro area contains the whole gamut of these elements.

  (3) This can also be applied to other ratios, such as the P/E ratio or the PBV ratio.

  (4) See J. Cochrane, «Discount Rates», The Journal of Finance, Vol. LXVI, No. 4 2011, and John Campbell, S. Giglio and Ch. Polk, «Hard Times», Harvard University Working Papers, 2011.

  (5) -For example, Andrew Haldane, «Risk Off», Bank of England, Speeches, 2011.

  (6) -For example, U. Malmendier and S. Nagel, «Depression Babies: Do Macroeconomic Experiences Affect Risk-Taking?», Quarterly Journal of Economics, Vol. 126 (1), 2011.

  Correctly identifying the causes of fluctuations in the risk premium is important for economic policymakers when designing measures of financial stability, as well as for investors, particularly those operating in the short term and who therefore depend critically on its performance. For those with a more medium or long-term approach, it's important to bear in mind what we have already mentioned: whatever the cause, an increase in the dividend yield associated with an increase in the risk premium ultimately means potentially more attractive returns in the future. Under this premise, and given the events of recent times, investing in a diversified portfolio of European shares is an option that has notably gained in appeal over the medium term; even though there's a small likelihood of 2012 still being disappointing.

  (7) -For example, Cochrane (2011) op.cit.

  This box was prepared by the Financial Markets Unit

  Research Department, "la Caixa"

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