Since the pandemic spread around the world and global equity markets fell in March 2020, equities have rebounded very strongly. With a rally in global equities of more than 70% (MSCI World including emerging markets between April 2020 and August 2021), many investors are wondering whether equity markets have become worryingly expensive.
As always, many factors are at play, but the role and importance of central banks and governments who provided support to corporates and individuals are difficult to ignore. It seems rational to wonder beyond the expensiveness of equity markets if they have had some distorting effect on the valuation of global equities.
Measures of equity valuations
Defining equity valuation is an exercise slightly more debatable than one might initially think. Equity valuation is typically measured as the earning of corporates vs. the price of the associated shares. There are though different definitions: Trailing earnings (such as the past 12 months), or forward earning expectations (aggregating the forward view of analysts’ estimate of future earnings). It can also be based on longer periods, or other measures of growth like return on equity. In summary, there are many metrics and associated models used to define equity valuation. For simplicity, we are looking at what is probably the most typical measure of equity valuation: forward 12 months price to earning’s ratio (12m Fwd P/E ratio). It is basically the earnings expected in the next 12 months divided by the current price, more simply how much you are paying for next season’s earnings. The interesting point about forward earnings is precisely that it is forward looking and doesn’t use past and outdated information from previous years. The major drawback is, of course, that it is based on corporate CEOs and financial analysts’ estimate of future earnings with all the uncertainties associated with them.
Looking at the current forward 12-month P/E ratio for world equities, it is presently trading at 18 times as can be seen on the chart below. Looking at it in historical context, it appears as relatively high and clearly higher than what was experienced since the global financial crisis of 2008. It was only higher than the current level during the tech bubble period at the end of the 90s.
There are however important questions which can’t be ignored while looking at current stock valuations and comparing them to history: Is it really comparable? Where do we stand in the current economical cycle? Do valuations have any strong predictive power?
Valuations in historical context
Looking at valuations throughout history provides some interesting anchor points. However, the world has changed significantly, and so historical context may not be a useful guide as to what should be considered expensive. Two aspects in particular are worth considering.
The most important one is the level of interest rates and the impact on equity valuation. Standard models to value equities use the level of interest rates to discount future earnings and the impact can be meaningful when rates are as low as they are now.
For example, the theoretical price of a stock generating an earning next year of £100 and growing at a rate of 10% per year would be around 3,800 based on a simplistic model (using 20 years future earning and a discount rate of 3%). If the discount rate is 2%, the theoretical price would be 4,400 and with a discount rate of 1%, the theoretical price would be more than 5,000 so 30% higher than initially.
With interest rates and bond yields likely to remain low for an extended period of time, having structurally higher equity valuation vs. history has some rational. The chart below normalising MSCI World valuations by the level of mid-term US bonds (so somehow P/E Ratio per unit of Bond yield) is showing that forward equity P/E in the context of low bond yield don’t appear particularly high.
A second point worth considering is the impact of sector composition in major indices and in particular US indices which are the dominant part of the global equity market. Global valuations metrics such as P/E ratios are often analysed for a given country index like the S&P 500 in the US, or the FTSE 100 in the UK. However, over time, we have witnessed significant shift in overall sector composition of those indices. The US market has become totally dominated by technology companies which wasn’t the case historically, except perhaps the end of the 90s and early 2000s with the tech bubble period.
Technology related stocks (which includes all companies that are indirectly related like real estate companies providing warehouses to tech deliveries or car manufacturers like Tesla) could represent almost 55% of the US index. With those companies generating high level of growth accentuated by the incredible shift seen during the pandemic, they tend to justify a higher valuation than other sectors (strong cash flow generation, highly robust business model with very large and global client base, ongoing disruption of established players and winners take it all mentality among other positive factors).
Some sectors like energy or materials which have typically lower valuations have dwarfed in size over the last 10 or 15 years. This shift in index composition is almost by itself a structural reason to expect a higher level of valuation in equity stocks.
Are Central Banks’ balance sheets driving equity markets?
While the action of central banks was important to stabilise equity markets and to provide support to the economy last year, equity markets are driven in the long-term by equity earnings and the increase associated.
As can be seen on the chart below, over the last 25 years, earnings and prices have moved in tandem. Corporate earnings’ increase remains the fundamental drivers of equity prices. This includes the recent years and arguably much more than the action of central banks. While the impact of central banks has been important to stabilise the economy and provide liquidity in the system, one shouldn’t forget that the increase in earnings has been very strong and currently largely higher than before the pandemic.
Does valuation even have predictive power?
With a relatively high equity valuation, the potential for future return is of course lower than during periods of historical low valuation. But lower expected future return doesn’t mean no return or even losses and trying to time equity by avoiding or reducing equity exposure can be very hazardous.
Forward earning expectation is only one part of the puzzle and can be volatile. During the Covid crisis, analysts’ forecast of equity earnings were rather low, showing a global equity market at a ratio above 20 (chart 1). Since then, global P/E ratios have reduced by 20% while the market has increased by more than 50% as corporate earnings delivered growth beyond the increase in equity prices and stocks are forecasted to deliver again strong growth in 2022. It is important to acknowledge that an investor who cut their equity allocation last year using high valuation as its main reason, would have missed one of the best investment opportunities of the last 20 years.
While there is definitely some merit in questioning the current level of valuation in equity markets, using current equity valuation as a decisive driver of decision in portfolio allocation might be omitting other important structural factors. The level of bond yields (which remain highly unattractive vs. the dividend yield on equities), the sector composition of indices or even simply where we are in the economic cycle. Expectation for corporate earnings is solid for the coming months, capacity utilisation is still below pre-covid levels in the US and has a lot of room to help improve future earnings and the reopening of the economy should help to sustain consumption, economic growth and ultimately equity markets.
Risk warning: As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past or future performance indicators are not a reliable indicator of future performance.