Citigroup has looked at periods in previous earnings recessions, when earnings were still plunging sharply, but rock-bottom valuations stabilised equities.
Their chart below shows the phases of a typical earnings recession, with trend lines for prices (black line) and earnings (grey line). Phase 1 is what we saw in 2008 - share prices dropped much faster than earnings. Back then, investors favoured defensives, and abandoned cyclicals.
Phase 2 is what Citi calls the "Twilight Zone". Earnings fall faster than share prices, and sector trends are much less clear. The bank says this is the zone we’re currently in. They also advise that it’s the right time to slowly increase risk exposure.
Source: Citigroup
"There is no need to chase rallies too hard," they caution, however. "Don’t get too depressed after a 20% fall and don’t get too optimistic after a 20% rally."
A turn in earnings takes us into Phase 3, during which Citi feels investors’ strategies should start to get aggressive. That’s when we’ll see cyclicals regain some popularity as investors become less risk averse.
The bank sees an earnings recovery in 2010. If we based it purely on valuations, as they’ve done, we’re not entirely convinced of this likelihood. We’d have to see market fundamentals stabilise for that to happen - and it’s too early to make that call.
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