The relationship between sales and earnings is best illustrated via profit margins; earnings/sales. As you can see above, profit margins matter a lot and can be incredibly powerful in gauging the general state of corporate fundamentals.
Currently, this is an issue to be wary of as global profit margins appear on the higher side of “normal”. While some may cite structural change via the move towards automation, perspective shows that this is potentially overhyped, margins did not expand structurally in the 1999 tech boom for example.
In fact, we can see that margins are subject to cyclicality and are currently at the highest level since the financial crisis. Therefore, for earnings to continue growing at the current stellar rate, either sales growth need to increase drastically, or profit margins must stretch further. Both are plausible outcomes, of course, although perspective shows that the probabilities are likely skewed to the downside. For this reason, it warrants general caution towards global equities.
Yet, if we split the global landscape into developed and emerging markets, we can see the valuation pressures being experienced are not the same. One means of demonstrating this is to use the “CAPE10” ratio, which looks at current market prices relative to long-term average earnings. CAPE stands for cyclically-adjusted price/earnings, which we calculate over a 10-year horizon.
A few clear observations become apparent. For instance, developed market equities are far more expensive than emerging market equities on this metric. This would hint that investors have been willing to pay a premium for developed market equities during the post-crisis period, with greater optimism bidding up valuations in these markets. Interestingly, since 2016, we have also seen emerging market valuations rebound, although from a far lower base. This divergence is of particular interest to us.
On a look-through basis, we can see where most of the developed market valuation pressure is coming from. The U.S. is now grossly overvalued according to our analysis, although the recent market setback has put the 10-year real return expectation back into positive territory.
Staggeringly, the U.S. market accounts for approximately 59.5% of the developed market basket, so has the ability to significantly impair the aggregated outcome. While this is a concern for market-cap weighted global holdings, it is also an opportunity to improve reward for risk, where we can limit our U.S. exposure in favour of more attractive markets.
Part of the reason the U.S. looks so expensive is the technology sector. This has been one of the most popular parts of the market to allocate capital, with strong revenue and earnings growth. The problem with this asset class is not the “story”, but rather the cyclical nature of the advancement and the unbounded optimism that is being priced in. This is particularly evident via the return-on-equity ratio, which is at the highest level since at least 1995.
In a forward-looking context, this is more of a concern than an endorsement, as the return on equity (ROE) carries an element of cyclicality and could significantly strain the sector if it reverted.
If stretching ROEs are a cautionary sign, what does a depressed ROE look like? We don’t need to look much further than European telecommunications, where we find quite a grim backdrop. These telecoms have been punished, in part due to their stagnant book value, but mostly due to their inability to turn around earnings. Whether the ROE of European telecoms is due to rebound in the near-term is anyone’s guess. However, if or when these companies find a way to plug the earnings hole, the long-term potential is significant.
