Darius McDermott, managing director, FundCalibre looks at current markets and asks: Should we be worried about market valuations – or s that the wrong question entirely?
A year on from the fastest global sell-off in history and markets have gone full circle from a valuation perspective.
Almost every region across the globe is looking expensive, regardless of which measure you look at. The US for example, which accounts for 60% of the MSCI All Country World Index, is more expensive than in any point in history, apart from the Dotcom boom.
But the question is: how relevant is history to today’s market?
There is no point in comparing any sort of P/E or CAPE chart from today and the 1970s, because there was a very good reason for stocks to be trading with a P/E of 7 in the 1970s – you had double digit inflation and interest rates, while US ten-year treasury yields were over 15%. Today we have a record low risk-free rate, driven by incredibly loose monetary policy. Clearly moving from 15% risk-free to zero will affect prices significantly.
This is why asking questions about valuations is potentially the wrong thing to do. You could argue that equity markets are still cheap relative to bond markets and could go much higher. The bond market has been completely manipulated by central banks which feeds into the stock market. Remember all financial assets are priced off the risk-free rate.
So what can impact the risk-free rate? That would be a change in monetary conditions and the only likely rationale for that is the big talking point in markets at the moment – inflation.
If inflation were to return to double digits, government debt yields would return to 10% or more – then stock markets would incur significant falls. By contrast, if the market turns deflationary, we can expect the dominance of growth stocks, such as technology, to continue.
Schroders points out there are some mitigating factors behind the high valuations in markets. For example, trailing price/earnings multiples have been distorted as earnings collapsed last year due to the pandemic. The same can be said for dividend yields, with companies cutting dividends across the board*.
This is commonplace when we have a negative shock to the system, with Schroders citing trailing P/E peaking in 2009 – during the Great Financial Crisis – and not the market peak. But regardless of these distortions, there is an acceptance markets do look expensive from a historical basis*.
The risk of inflation is clear. I’d use the example of e-commerce companies: they are trading on phenomenal multiples meaning you have to look a number of years into the future before you see any profits or free cash flow. There is no inflation factored in to those valuations – if there were, then the yields would back up. Investors will be sitting there with their fingers crossed that nothing changes anytime soon.
Murray International Trust manager Bruce Stout says valuations are increasingly polarised at the moment. His team is finding a number of good businesses at reasonable valuations, which are based on the view that the world has completely changed and we are not going to use the likes of commodities, insurance or banks to the same degree in the future. Effectively they have priced in low interest rates forever.
Stout adds there is anecdotal evidence that inflation is everywhere in markets (food, energy and services for example) and although it’s not rampant – its existed in the system for the past decade. He says there is nothing priced in the bond market for inflation and if there were, we would see some back up in yields, changing the complexion for cyclical stocks.
TB Wise Multi-Asset Growth fund manager Vincent Ropers says a global economic recovery is not fully priced in yet, pointing to a plethora of cyclical companies which have not recovered last year’s losses. He feels broad equity indices can be misleading indicators and are increasingly a reflection of the success of a minority of stocks and can easily hide the disparity between growth and value stocks.
Rathbone Strategic Growth Portfolio manager David Coombs believes the market has got overly excited about the vaccine, indicating that he believes a recovery will be slower than perhaps people think. He is also wary some of the damage to the global economy – which has been hidden by government support systems – is still to play out. “A lot of people have lost their jobs and some of those jobs will not come back,” he said. “I think the recovery is overstated and I see little threat from inflation, although there will be pockets.”
We cannot ignore the valuations, particularly in the US, but you have to accept some risk in a market where the easy money has now been made.
* Source: Schroders – Are any stock markets cheap going into 2021?
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.
This article was first published in the March 2021 issue of Professional Paraplanner