Flying high: should we be worried about stock market valuations?

The pace of the equity market recovery from the shock of coronavirus has been staggering. Many major markets have recovered all of their losses – and more – since reaching their lows just over a year ago. Investors are now expecting a strong recovery in both economic activity and corporate earnings. But will the reality of the rebound meet their expectations? Or will disappointment trigger a market correction as reality sinks in? Much depends on exactly how much optimism is baked into today’s valuations.

Assessing value

Investors tend to think about the valuation of equities, and other financial assets, in three broad categories:

1. Relative to fundamentals: how does the price compare with the current level of revenues, earnings, cash flows and income generated by the company?
2. Relative to history: does the company’s current valuation represent a premium or a discount to its historical average, and if so can it be justified?
3. Relative to peers and other assets: how does the valuation compare with those of other companies within the same sector or region, and with other market-traded assets such as bonds?

When assessing the current market using this framework, there is good reason to fear that asset prices, like Icarus in the mythological tale, may be straying a little too close to the sun. As of early March, the value of the world equity markets, based on five commonly used valuation metrics (see table below), are elevated both in absolute terms and relative to the average over the last fifteen years. Valuations appear to be high across most major regions and sectors, with few pockets of value immediately evident. 

We are now in the unusual situation of global equities, bonds and credit all trading at some of the highest levels ever. What makes this period of expensive valuations particularly unusual is that it coincides with low levels of economic activity. This suggests that investors are pricing a lot of future growth into today's valuations.

Perhaps most concerning has been the rise in price of so-called “high growth” assets. Companies seen by the market as leaders in technological disruption, such as Tesla, have benefited the most from the unprecedented increase in global liquidity and retail participation in markets. Outside of equity markets the same phenomena has been visible in the recent price moves of crypto assets such as Bitcoin which has been labelled by some as “digital gold”.  

Pegasus to the rescue?

So are equity markets doomed to the fate of Icarus? Not necessarily. There are three key arguments that could justify current valuation levels. 

Firstly, while we are seeing signs of over-inflated prices in some parts of the market, others do not demonstrate the same level of excess. In fact, if you exclude Tesla, the valuation of the US equity market has actually been falling since the summer of 2020 – showing the extent of the impact of a small number of high-flying stocks.

Excluding Tesla, US equity valuations have drifted lower since summer

Price earnings multiple, based on estimated earnings over next 12 months

^{Source: Cazenove Capital}

The second defence is that owning equities remains attractive relative to other assets, particularly bonds, even if yields have risen in recent weeks. Many investors have concluded that there is no alternative to investing in equities if they want to preserve the real (adjusted for inflation) value of their wealth.

The third and perhaps most important argument is that markets are simply pricing in future economic recovery. If it is as strong as anticipated, asset prices will not look as expensive as they do today. Confidence in this recovery is arguably higher given the clear message from governments and central banks that they will provide support while Covid-19 continues to impact activity. It is almost as if Pegasus was on standby to swoop in and catch Icarus in the event that his wings malfunction and he begins to fall.

Avoiding hubris 

Whilst these arguments are supportive, it would be hard to make the case for valuations rising much higher from current levels. There is a risk that the anticipated recovery fails to materialise – perhaps due to new variants of the virus. In this case, much of the future growth priced into equity markets could quickly unwind. There is also a possibility that policy makers have overstimulated the economy, creating too much inflation and forcing them to withdraw the safety net of low interest rates and asset purchases that investors have come to rely on. The recent rise in bond yields is evidence that the market is assigning an increasing probability to this outcome.

Our base case remains that the economy will find a path between these risks, supporting current valuations over the near term. It is also worth noting that the prospects and valuation of our holdings are different to those of the market as a whole. We continue to focus on constructing portfolios with more exposure to those areas of market where growth is not over-priced and offers better value for money.

Understanding the data

The table above shows the valuation of global markets using five different indicators. 

Forward P/E
Calculated by dividing a stock market's total value by the forecast earnings of companies in that market over the next 12 months. One drawback of this measure is that the measure is based on forecasts – and analysts can be over-optimistic.

Trailing P/E

It works like the forward P/E but takes the past 12 months’ earnings. This involves no forecasting – but the past 12 months may give a misleading picture.

CAPE

The cyclically-adjusted price to earnings ratio compares the current price with average earnings over the past 10 years, adjusted for inflation. The idea is to smooth out fluctuations in earnings. 

Price-to-book ("P/B")

Compares price with the value of assets in company accounts. The measure has less meaning for technology and service companies, which may have few physical assets. But these companies are becoming increasingly important. 

Dividend yield

Yield has been used as a tool to forecast future returns. Low yields have been associated with poorer future returns.