This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Global Strategists Robert Jukes and Edward Smith explore the notion that the equity bull market is in danger of becoming long in the tooth.
Few analysts disagree that the opportunity for extraordinary long run returns has closed. Three years ago equity risk premiums – a function of the compensation investors are willing to accept for the risk of companies’ future earnings – were extremely high. Today they have come down closer towards the pre-crisis norm. This is in part due to QE forcing investors to accept a much lower compensation for equity risk as they sought an acceptable rate of return.
However it is also about investors becoming more realistic about the prospect of future earnings. If the value of a company with zero growth potential is calculated by projecting today’s earnings into perpetuity, the difference between today’s market price and the value of that zero-growth perpetuity is arguably the ‘present value of future growth opportunities’. In short, without a powerful catalyst – and we do not believe there is one on the horizon – there is little room for valuations to continue their march higher. Instead, rather than continue to pay more for the same level of earnings, investors will look to earnings growth to drive returns; a key characteristic of an aging bull market.
In an aging bull market, equity investors must become more selective. A greater dispersion of price momentum among industry sectors is also a key characteristic, and we can see that happening today. Many of those companies that needed a de-frothing have actually done well over the last six months for a reason – earnings growth, both actual and forecast.
Earnings breadth for the soft technology sector has surged ahead of the wider market this year, as it has done for biotech – the two sectors about which many commentators are talking bubbles. Earnings breadth is usually a good leading indicator of relative returns. At price-to-earnings ratios of 24x and 22x forward earnings, internet and biotech stocks respectively are trading below the valuation multiples at which they traded in the five years after the dot-com crash of the early 2000s. Although there are some clear pitfalls, we do not believe it is time to shun these high-growth sectors, and judicious stock selection focusing on a track record of quality and growth should do well.
Turning to the accusations of M&A-driven fizz, the resurgence of mergers and acquisitions (M&A) is one of the reasons why we have favoured mid-cap stocks in the US and the UK, aside from the fact that they are better keyed into domestic growth and have little exposure to emerging market risk factors. Again, we encourage investors to disregard the hyperbole that markets are in the midst of an unsustainable M&A bonanza. M&A as a percentage of Gross National Product is actually still rather anodyne compared to the past fifteen years. We believe M&A will continue to be a return driver. Free cash flow yields are still high and with the first interest rate hike now in sight, companies will likely bring forward investment plans as they realise time is running out for them to exploit the startlingly compelling economic incentive to invest.
This will likely herald greater internal M&A and reverse the decade long trend of UK and US companies making acquisitions overseas. If earnings are difficult to come by, companies will continue to turn to M&A to drive returns and we continue to emphasise that positioning for earnings growth is the key to outperformance in this aging bull market.
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