Judging only by current equity market valuations, global equity investors are significantly more likely than usual to achieve only below average returns over the next 12 months, if prior correlations remain a guide to the future. Average price/book multiples for world equities are once again at peak levels, similar to those prevailing in 2007 and 2000, and this is reinforced by a similar picture for P/E ratios. We believe investors should factor in the possibility that broad equity market exposure may result in weak or negative returns and stock-pickers cannot rely on a tailwind of benign markets over the next 12m.
In our view, 2016 was the year that investor positioning confounded many portfolio managers. Crowded bearish trades in energy and commodity sectors in Q1 16 were reversed by Q4 16 as the anticipated collapse in Chinese activity did not occur. The Brexit event, in some quarters believed to be a potential catalyst for significant volatility in world markets, failed to deliver anything other than a modest and short-term dip.
Similarly, Trump’s election as US president was greeted by a very strong rally in US markets, even as it remains highly uncertain whether any actual US fiscal stimulus will match election promises. Furthermore, Trump’s much more controversial geopolitical and trade policy initiatives appear to have been largely ignored by investors, as has the likely tighter offsetting monetary policy of the US Federal Reserve. Fed policy makers are clearly uneasy with the idea of a large fiscal stimulus at a time when the US is at full employment, as highlighted by San Francisco Fed President John Williams’ comments in the FT this week. We also note that consensus earnings forecasts have moved only a little higher since the US election.
Comparing the current (unweighted) global sector average price/book ratio to its long-term average leads to an uncomfortable conclusion, Exhibit 1. It is suggestive that returns over the next 12m are likely to be lower than average and there is also a greater than average risk of a meaningful decline, based on historical correlations, as shown in Exhibit 2.
Exhibit 2 also shows that the variation in short-term returns is only in part explained by mean reversion in valuations. However we would highlight that over the last 35 years the most severe drawdowns of more than 20% – which are arguably the only ones which really matter – have only occurred when price/book valuations are as high as they are now.
Looking across world sectors, there is also an unusually large proportion of sectors trading at more than 15% above their price/book average versus those trading more than 15% below. This is also a signal suggestive of caution in terms of the outlook for equity markets, Exhibit 3. The sectors trading below their long-term average price/book ratios are predominantly cyclical, such as mining and energy. While we favoured these names in 2016 as they felt oversold in the circumstances, we believe the Trump rally represents a good opportunity to take profits.
Behavioural finance would suggest that it can be very easy to become caught on a compelling narrative while under-emphasising comparatively dull statistics which may have little emotional resonance. Furthermore, the prevailing market narrative often seems formed from the rather clearer image in the rear view mirror, while investors need to look forward.
At present, the potential impact of a large US fiscal stimulus is at the forefront of investors’ minds, even if the details remain uncertain. But over the last 30 years casting narrative aside and focusing on the raw valuation data would have minimised exposure to the equity declines of 1987, 2000 and 2008.
Entering 2017, we increasingly cautious on the overall outlook for equity markets and would continue to focus equity portfolios on highly specific or event-driven situations. While it is difficult to call the top of a rally as powerful as that in mining and energy with precision, we would also continue to scale back overweight holdings as the prospect of abnormal gains appears to have passed.