Author: Alastair George
Since 2009, bearish equity investors have been stymied by never-ending reductions in global interest rates and repeated prolongations of the economic cycle. It has been described as the most unloved bull market, in part because it is happening for the ‘wrong’ reasons. Revenue growth rates for the market as a whole have been sluggish while EPS growth has at times been driven as much by financial engineering in the form of share buybacks as it has from growth in net income. Market performance has also been skewed towards a relatively narrow segment of the overall stock market, to the detriment of the generalist active manager.
Furthermore, the surge in digital growth stocks in the most recent 12 months places another question mark over the actual value added by active value managers. The top-performing fund managers now are those who have continued to ride technology stocks to ever higher multiples or even invested in alternative digital assets such as Bitcoin. Coal miners may be out of favour from an ESG perspective but highly energy consumptive Bitcoin miners appear to be exempt from such considerations.
For experienced investors who can remember periods of euphoria such as the stock market bubble of 2000 or the mortgage finance bubble of 2007, valuation alarm bells are ringing. The Nasdaq index was up over 40% in both 1999 and 2020 – and arguably for similar reasons. Central banks, which were in the process of removing the punch bowl as recently as 2019 have quickly reversed course and added a stronger brew in response to COVID-19. The bogeyman may be different – it was the millennium bug in 2000 – but the result has been the same. Loose monetary policy applied to the broad economy at the same time as a surge in spending on technology services has seen technology stocks rocket.
Historically, value has mattered. Periods in which share prices were at a relatively low multiple of book value or alternatively 10-year trailing average earnings have been followed by the strongest 10-year returns. The quintile return ranking from the Shiller 10-year P/E for US equities is well known and accords with the intuitive result that investing at low valuations offers better returns than investing at high valuations. With the current Shiller P/E for US equities firmly in the top quintile, the measure currently indicates a relatively sluggish period for US equities in the decade ahead.
Collectively, this fact is both known and understood by institutional investors. However, institutional fund managers are also presented with few attractive alternatives at present. 10-year government bonds are priced to lock-in losses in real terms, if central banks can make good on their inflation targets. There is also a risk that the Rubicon of fiscal sustainability has been decisively crossed as there has been no substantive political opposition to a worldwide deficit spending spree in response to COVID-19. This fiscal determination to support the economy may have rescued equities and corporate credit, yet current government bond yields still offer a derisory risk premium for any unanticipated uptick in inflation in coming years.
The question of over-valuation should also not be over-simplified. Splitting the largest 2,000 global companies into revenue growth quintiles confirms that the surge in price/book valuations over the past year is concentrated in the highest growth segments of the market, Exhibit 1. We note also that valuations for these faster growing companies have been expanding since 2014, lending credence to the idea that a degree of complacency could now be setting in. Valuations for faster growing companies have not mattered for over six years. Furthermore, we can see a notable further increase in price/book valuations for the very fastest growing 10% of global equities (D10).
Exhibit 1: Valuations have surged for the fastest growing global equities
Source: Refinitiv, Edison calculations. Note: Forward price/book by growth quintile (Q1 = slowest, D10 = fastest decile).
Outside these segments we observe that slower growing companies may be trading above their 10-year price/book multiple, but not excessively so. With corporate profits underwritten by fiscal policies and markets supported by ample liquidity, it is quite possible to argue this is precisely what should be expected at this stage in the pandemic and as vaccination programmes get underway. Therefore, framing the question of valuation in binary terms, such as all-in versus sell everything, may make for good headlines and stimulate trading activity but in our view it provides the wrong context for long-term decision making.
The data suggest that outside the fastest growing segments of the market, long-term investors are balancing the low yields available on risk-free securities with genuine inflation uncertainty and the timing of the likely exit from COVID-19 social restrictions.
Current modestly higher than average valuations for ‘normal’ rather than ‘super-normal’ companies point to investors consciously accepting lower than average return expectations for equities at present. If so, this is a recipe for an equity market to move sideways rather than face any dramatic reversal, provided central banks do not remove the punch bowl too soon. In addition, new strains of coronavirus must not challenge the consensus that the economic impact of the pandemic will fade by mid-2021.
Since we published our strategic outlook for 2021 in late November with a positive view on global equities, emerging markets have risen in US dollar terms by 11% and developed markets by 7%. There has been positive news politically in terms of a Brexit deal but on the other hand the second wave of the COVID-19 pandemic has been more severe than we initially expected and countries such as China, which had been COVID-free, have started to discover more cases.
While we are not expecting a major reversal in sentiment, valuations for the world’s fastest growing companies are at 10-year highs, relative to the other 75% of the market. We believe investors should now carefully review their holdings in this segment of the market with a view to taking profits. Nevertheless, for the remainder of the market the data suggest the argument for running for the hills with bond yields at such low levels has less merit.