Strategy & economics

There's a lot in the price


Richard Jeffrey

Richard Jeffrey

Chief Economist

Some market aphorisms work better than others. ‘Sell in May…’ is probably the best known, and beloved of equity brokers who are in the process of booking their long summer holidays. ‘Better to travel than to arrive’ has no fixed calendar position and refers to an investor, perhaps simply human, preference for anticipating rather than actually experiencing something pleasurable. ‘Sell in May…’ is quite often a sensible investment strategy; ‘better to travel…’ depends on the degree of certainty that markets are able to ascribe to their expectations. In addition to the estimated probability of a favourable development taking place, behaviour is also influenced by the capacity of investors to back their expectations with money and underlying market valuations. Even on the assumption that investors do have the wherewithal to buy assets that are reasonably attractively priced, at some stage their prior hopes have to be validated.

So, this is where we find ourselves at the start of 2014. Western equity markets posted substantial total returns in 2013 – much greater than might be expected in a normal year and much greater than seemed justified by developments during the year itself. But it was a period in which there was an evident convergence in the factors required to boost investor sentiment: hope, cash and value. And of the three, in this case, the greatest was most definitely hope. The hope was, and remains, that Western economies have embarked on a self-sustaining recovery that will see corporate profits rising at least in line with, if not faster than, nominal GDP. That expectations should run ahead of reality is entirely normal at this stage of the economic and market cycles. However, quantitative easing (QE) has added significantly to the weight of money invested in this hope. This means that it is all the more important that economies now begin to justify the faith of the investor community.

Using Datastream data, the Historic PE on the US equity market at the start of 2013 was slightly under 16x; by the end of the year it was a shade below 20x. So, of the 30% rise in the Datastream US market index, only 5% can be attributed to earnings growth. The remainder was the result of PE expansion, and that reflects not a small amount of hope value. In the UK virtually the whole of the 16% rise in the market, measured using the Datastream Index, resulted from the increase in the market PE.

That investors were willing to invest so much in their hopes was due partly to liquidity and partly to valuation. Both in relative terms and absolute terms, equity markets looked attractively valued at the start of 2013. An analysis of cyclically adjusted earnings in the UK, for example, suggested that the adjusted PE on the market was appreciably lower than its long-term average level. US equities did not look quite such good value on this basis, but they were by no means expensive. Other markets in the developed world also stood on reasonable cyclically-adjusted PEs. Moving the story twelve months on, the UK market remains attractive, but the US market has moved into more expensive territory. This leads to two conclusions. First, we now need to see earnings growth coming through to justify the PE expansion that has occurred. This is particularly true in Europe (including the UK), where earnings outturns over the past two years have been woeful both in their own right and when compared to expectations at the beginning of each year. The second conclusion is that, even with better earnings momentum, the scope for markets to continue their bull run is more limited than a year ago, unless growth is appreciably faster than expected.

A further factor that must be included in this analysis is the impact of QE tapering in the US. While there is some reason to believe this will help equity markets by triggering flows from bonds into equities, it is evident that all markets have benefited from the liquidity that has been pumped into the US (and world) financial system through QE. One way of looking at QE is that it has made investing in financial assets less risky. This has been reflected in higher valuations for fixed interest securities and lower volatility in most asset markets. So, tapering will likely see volatility return to more normal levels (possible after a period of higher-than-normal price fluctuations). While, in the longer term, a normalisation of monetary policy should be seen as a good thing, it implies that the risk of holding financial assets will rise, at least in the short term.

So this leaves us with a bottom line that Western equities should still make progress during 2014, but we should not expect a repeat of the super-normal returns enjoyed during 2013.

This article is issued by Cazenove Capital Management which is a trading name of Schroder & Co. Limited, 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Issued in the Channel Islands by Cazenove Capital Management which is a trading name of Schroders (C.I.) Limited, licensed and regulated by the Guernsey Financial Services Commission for banking and investment business; and regulated by the Jersey Financial Services Commission. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital Management unless otherwise stated.