By Kerry Craig
Global equity markets have been hitting fresh highs each week as investors continue to add risk to portfolios. However, it is impossible to speak about equities at the moment without the conversation very quickly turning to excessive valuations and possible asset bubbles. Some people are worried that the party is winding down, while others are banging on the walls asking for the music to be turned off.
In its recent annual report, the Bank of International Settlements (BIS) issued a stern warning about “extraordinarily buoyant” capital markets that it believed were becoming detached from economic reality. For good measure, it added that global markets remained “under the spell” of central banks and extremely accommodative monetary policy. Quite a buzzkill, but as the BIS is tasked with promoting monetary and financial stability, well it would say that, wouldn’t it?
It’s easy to agree with the assertion that investors have benefitted from sustained central bank action and that the historically low interest rates have pushed many savers towards riskier assets as they sought higher levels of income. You could also agree that valuations in equity markets have shifted very quickly over the last 18 months. But I would not go as far as “extraordinarily buoyant”.
The question of valuation is a good one though, and it is not remiss for investors to be asking whether they are still getting good value out of equities. The more meaningful question however, is whether better value can be found elsewhere. Relative to fixed income and government bonds, the answer is still no. A comparison of the earnings yield on S&P 500 to the yield on the 10-year US Treasury (the so-called “Fed model”) illustrates that equities continue to offer a higher yield than is available on government bonds and therefore that investors are still better off with equities over bonds. This comparison is, admittedly a little simplistic as it doesn’t compare like-with–like, since equities have a credit risk element that government bonds don’t. However, even when compensating for credit risk, by using a BAA corporate bond instead of a government bond, equities still look relatively more attractive.
So if equities still have the edge over bonds, how do they look compared to their own history? For equity market bears, the favourite measure to look at is the Shiller cyclically adjusted price-to-earnings ratio (CAPE). The CAPE looks at the equity market price level compared to the inflation adjusted average earnings of companies over the prior 10 years. The theory is that looking at the average earnings over a 10-year period presents a valuation more in line with the business cycle.
On this metric equities do not look cheap, in fact they look quite expensive as the current valuation is about 25.6 times is well above its long-term average of 16.5 times, but far from the giddy highs of the 2000 technology bubble. Some investors like to use the CAPE measure because it has a decent record of predicting long term trends in equity markets.
The key word in that sentence is long term. Many investors have a much shorter time horizon of perhaps a few years. The CAPE, in fact, is not a great way of judging the best time to enter or exit a market. Using the Shiller CAPE as a guide, investors should have exited the market a couple of years ago and would have missed out on the significant returns of 2012 and 2013. Furthermore, as the CAPE measure uses the earnings of the last 10 years, the current valuation is still being weighed down by events of the past decade, including the largest decline in S&P 500 earnings for more than fifty years.
Using the more generic price-to-expected earnings measure, or forward P/E ratio, US equities are closer to fairly valued. At the end of June the forward P/E on the S&P 500 was 15.6x just a smidge under its average since 1989. It is worth remembering that when something becomes fairly valued it doesn’t suddenly become unattractive. Equities can become expensive—or even very expensive—before a pull back in markets occurs.
Investors will always fear the next bear market looming large on the horizon. But much like a New Zealand All Black winger gracefully sidestepping an English front row forward, timing your move is always the hardest part. There is no clear answer, but high valuations themselves are probably not enough to cause a correction in markets, and it is likely that that another catalyst will be needed.
Kerry Craig is global market strategist at JP Morgan Asset Management
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