Commentary on Political Economy

Thursday, 10 December 2020



The valuation warning signs for stock markets

Investors remain overweight equities even though US valuations have returned to levels last seen in the January 2000 dotcom boom © Financial Times

The writer is co-founder and chief investment strategist at Absolute Strategy Research

The rationale behind the current optimism among many equity investors is shifting as markets emerge from the pandemic shock. In the yield-starved pre-Covid-19 world, a common mantra of the bulls was the acronym TINA — there is no alternative. Now that has mutated to TRINA — there really is no alternative.

Investors remain overweight equities even though US valuations have returned to levels last seen in the January 2000 dotcom boom. Are investors right to be so bullish when share prices are so high relative to earnings and cash flow?

Although every market rally derailment is different, there are common themes that occur on most occasions. The first is the role of implicit assumptions that may appear bullish but can also be seen as an important risk factor. Second, there is never a single cause: it is always the layering of risks and assumptions that leads to the ultimate crisis. The current complacency about global equities has many of these characteristics.

Inherent in the current market optimism are three crucial assumptions. First, valuations do not matter any more. Second, interest rates will stay low for an extended period. And third, loose monetary and fiscal policy combined with the Covid vaccine will return us to the “status quo ante” and the investment regime of the past five years.

Scatter plot of Total return (compound annual growth) over the subsequent ten years (%) against Trailing price/earnings ratio

The reality is that equity valuations always matter. Less so in the short run, but more so in the long run. One benchmark is when the ratio of US share prices to earnings over the previous 12 months rises above 30. Since 1950, whenever that threshold has been brea

ched, the subsequent 10-year annualised returns for US equities have rarely been above 5 per cent and often below minus 5 per cent.

Our own valuation composite, which combines six common valuation metrics such as prices relative to earnings and cash flow, shows valuations more extended than at any time since January 2000. A similar story is shown by the “Tobin’s Q” ratio popularised by American economist James Tobin, which measures the market value of a company relative to the replacement cost of its assets. That ratio is back to levels seen only once since 1950 — in January 2000.

The pushback to concerns raised about such levels is that traditional valuation metrics are less meaningful given that future earnings are discounted by rates now close to zero.

I worry, however, that these bullish investors are looking to “have their cake and eat it”. They expect unemployment to fall and earnings to post a healthy recovery yet expect policymakers to keep interest rates on hold and bond yields to remain low and stable. But at what point will policymakers decide that they have done enough? They will be keen to avoid a repeat of the ‘taper tantrum’ in markets in 2013 when the US Federal Reserve signalled a tightening in policy. However, policymakers may find it hard to control longer-term bond yields if current expectations of the economic and earnings recovery play out.

The danger in relying on overvalued bonds to justify overvalued equity valuations is that any volatility in rates, driven by activity or inflation, could destabilise the equity market complacency. The combination of both bond and equity valuations being this stretched has only been seen twice since 1950 — in 1998-99 and 1986-87. Neither of those periods ended well.

Implicit in the relaxed consensus about equities also appears to be a view that the vaccine will deliver an extension of the previous cycle and a return to the status quo ante. We suspect that a sell-off in early November of some of the more faster rising stocks provided a warning shot that the world has changed.

Investors are now focusing on the scope for cheaper stocks to outperform as earnings become more plentiful and margins recover toward their 2018 peaks. However, a greater focus on value means a greater focus on valuations. Investors looking to buy cheaper ‘value’ stocks will become more wary of buying growth stocks which command a premium because they have higher potential earnings.

The good news in 2021 is the likelihood of a meaningful economic recovery. The bad news, however, is that this very success could usher in a new investment regime that will probably challenge many of the assumptions on which current valuation optimism is based. Sometimes it isn’t what you know is risky that is dangerous, it’s the things that you think are safe but aren’t that are the problem.

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