Valuations on equity markets are high by historic levels. A recent report by Goldman Sachs shows the forward P/E multiple of the S&P 500 is up by 80% since 2011, while the trailing P/E multiple is 22x, against a long-term average of 16.7x. That should make uncomfortable reading for equity market investors.
Lower bond yields mean you need to rethink asset valuations
However, there is an argument gaining traction that equity markets should trade higher in a climate of lower interest rates and lower growth. The growth they provide is more valuable. While investors should always be wary of the phrase ‘this time it’s different’ – might it be?
BlackRock has been an advocate of this theory. In a recent paper from the group’s Investment Institute, it said: “Structurally lower bond yields mean there is a need to rethink asset valuations. Take equities. The earnings yield of US equities – the earnings per share divided by the share price, or the inverse of the price-to-earnings ratio – gauges the attractiveness of equities versus bond yields.
“This measure puts US equity valuations in the richest quartile of their history. Yet the earnings yield still looks attractive versus bond yields. Also, we see less reason to expect equity valuation metrics to fall back to historical means in a world of lower rates.”
Missing Out on Potential Returns
It points out that in an environment of lower growth and interest rates, comparing valuation metrics to past levels may not be a good guide to the future and equities may actually be cheaper than they look. Investors moving out of equities on valuation grounds could be missing out on returns.
Mitul Patel, head of interest rates at Henderson, sees some merit in this argument, saying that while long-term bond yields remain low, higher equity valuations can persist. He says: “Equity valuation models typically discount future dividends by long dated yields plus an equity risk premium.
“Therefore, low long-dated bond yields has led to high price/earnings ratios and high valuations, particularly for companies that have a steady and reliable dividend stream. In addition, the equity risk premium imbedded within valuations do not look excessively low, which suggest equity markets could withstand a modest rise in bond yields.”
Longer-dated bond yields have been rising as fixed income markets have increasingly priced in a longer-term decline in rates. This shows many still believe that in the longer-term, the global economy is not strong enough to withstand the withdrawal of loose monetary policy.
What Should Investors Do?
However, for equity investors, this feels like an uneasy equilibrium. Yes, for the time being a marked rise in interest rates looks unlikely, but it is not an impossibility. Patel says: “Should central banks raise interest rates by more than 1%-2%, longer dated bond yields are likely to rise which could pressure on equity valuations. And while moderate levels of inflation are typically good for equities, a big increase in inflation is likely to put pressure on both bonds and equities.”
As such, plenty still believe equity markets are vulnerable even if they recognise that lower-for-longer interest rates means equity market valuations can be sustained in the short term: Goldman Sachs, for example, expects the S&P 500 to fall 3% to end the year at 2,400. There is a marked difference between a stock that may not fall, and a stock that has further to rise.
Recent movements show the extent to which some sectors are ‘priced for perfection’ At the end of July, shares in tobacco groups Marlboro and Altria fell nearly 10% in response to an FDA announcement saying that it would explicitly target nicotine and addiction to cigarettes. This type of action from policymakers has always been a risk and should not have been a significant surprise, but valuations left no room for error.
A Word of Warning
James Klempster, head of portfolio management at Momentum Global Investment Management, says they take valuations back to stock fundamentals and usually assume mean reversion. In May, they saw valuations as too high, and placed a number of put options on the market as a safety net. However, he adds: “Valuations have started to improve because earnings have improved. It has pulled down the P/E ratio slightly. We still believe that over a five year period, the equity market is the place to be.”
He says that he is nervous of any claim that “this time it is different” and still believes that high valuations should warrant caution. He says that there has been some ‘misplaced complacency’ in equity markets over the past few months, though this has diminished recently.
The low interest rate and low growth environment do change the comparative value of equities over bonds. However, it doesn’t mean that investors shouldn’t be alert to high valuations. If expectations of interest rates tick higher, some parts of the market may still be vulnerable. Valuations may be able to stay high longer than expected, but there are still risks for investors.
