The impressive gains made by equity markets this year have left valuations looking fuller than they were 12 months ago, says Dean Turner, Investment Strategist at HSBC Private Bank…
Nevertheless, we believe that equities will continue to make progress over coming months, driven by earnings growth that is supported by the recovering global economy.
As the US debt ceiling negotiations reached a positive conclusion last week, investors’ appetite for risk resumed, pushing stockmarkets higher, and driving the S&P 500 index to an all-time high. The recovery of stocks has moved valuations in some markets to within a whisker of their long-term averages, leading many to question if stocks can make further progress. In our view, valuations are unlikely to be an obstruction to share prices in the coming months; however, the key driver is likely to be a continuation of earnings growth.
To be sure, the rise in equity prices so far this year has exceeded most strategists’ forecasts, and has largely been driven by a re- rating rather than by stellar earnings growth. However, it should be noted that the revaluation has come from a very low base – at the start of the year the 2013 PE ratio for the S&P 500 index stood at 12.8x, today it is 15.2x, an increase of 18%.
Many of our readers may question the wisdom of buying into equities following such a strong run in markets, especially as the S&P 500 index has reached new highs. In our view, focusing on the index level can lead to the wrong conclusions. Over the long term it is natural for stock prices to rise as earnings grow; only if profits were not rising would this be a cause for concern, but as can be seen in figure 1 below, this is not the case. Thus, although US stock prices are at all-time highs, so are US company earnings. Thus, in our view, the current rally appears to be built on solid foundations.
Are stocks cheap or expensive? This is not an easy question to answer, as different indicators will give us conflicting views. For example, in figure 2 below we show the widely known and often cited Cyclically Adjusted PE (CAPE) ratio for the S&P 500, a creation of recent Nobel laureate Robert Shiller.
According to the CAPE (current level 23.5x) US stocks look expensive which could suggest that future returns may be below long-term averages. However, before we draw this conclusion, it is important to understand the composition of this valuation tool. The CAPE ratio is calculated by creating a ratio of real-time prices relative to an average of the last 10 years’ earnings. The intuition behind this is that by taking a long-term average of earnings we can smooth out cyclical fluctuations in corporate earnings. By following this approach, the CAPE captures much historic data but no forward looking data which can be an important driver of market returns. To be sure, the CAPE has been useful in identifying periods of extreme optimism and pessimism, but its track record at identifying turning points in the earnings cycle, such as in 2004, is more patchy.
An alternative to looking at historic earnings data is to look at expectations. For this measure, we compare real-time prices, with expectations for earnings over the next 12 months. This gives an altogether different answer to the question about stock valuations.
The purpose of showing these two conflicting measures of valuation is not to confuse, it is to highlight that there is not a shortcut to the answer. In our view, when considering the valuation and outlook for stocks, investors need to look at a number of different measures, as well as considering the economic outlook. The major flaw in using measures that rely on analysts’ forecasts is that they are notoriously bad at predicting recessions, such as in 2008. However, we believe that in time of relative economic calm, forward earnings estimates can be more useful when valuing stocks as equities prices tend to be driven more by expectations about the future than they are by the facts of the past.
Today we find ourselves in a period of economic growth, globally. Moreover, we believe that economic growth in 2014 should be higher than in 2013, which leads us to believe that corporate earnings growth will be positive over coming quarters. This environment makes us lean in favour of valuation measures that take into account the potential for earnings to grow, which leads us to conclude that, at the present time, stocks in general have headroom to make further gains.
Valuing stocks in absolute terms as we have done above is only part of the story. In our view, the most important decision an investor can make in his or her portfolio is deciding how much to allocate into higher risk (equities) and lower risk (bonds) assets. Thus, in our view, it is instructive to compare the relative valuation between the two, a task we have performed in figure 4 below. This measure compares the earnings yield (the inverse of the PE ratio we used in figure 3 above) against the yield available on 10 year US Treasuries. The intuition here is that when the gap is large and positive, stocks look attractive relative to bonds.
Although stocks have rallied significantly in recent months, and bond yields have risen a little, the valuation gap between the two still looks high compared to history. To be sure, this measure alone does not imply that stocks will rise further in coming months – which incidentally is our expectation – more likely, it points to a combination of rising stocks and increasing bond yields over coming quarters. This process will likely be more beneficial to holders of stocks than bonds over medium term.
When considering the economic and investment landscape, our view remains that an environment of positive economic growth will be beneficial for stocks over the next 6-12 months. To be sure, we believe that the pace of gains will slow, as valuations look fuller than at the beginning of this year, leaving less headroom of upward re-rating. Nevertheless, we believe that the potential for earnings growth and still very low yields in the sovereign bond markets should continue to encourage investors to allocate more to equities.
We retain our preference for developed market stocks, favouring US, European, and Japanese equities. In our view, recovering economic growth should be supportive for earnings in these regions, thus we favour adding to some of the more cyclical areas of these markets.
