In 2019 the global economy has gone into a marked slowdown. US-China relations have remained tense. Drones have attacked oil infrastructure in the Middle East. Global corporate earnings growth has collapsed towards 0%.
If at the start of the year you had foreseen this cavalcade of bad news – what would you have predicted for stock market returns?
I doubt that many predictions would have stretched as high as the 21% that US equities have managed to deliver in dollar terms so far. Nor the 16% from European equities or the 14% from the UK, in euro and sterling terms, respectively.
So what has been behind this? It has certainly not been fundamentals.
The outlook for the corporate sector has been continually downgraded throughout the year (see chart). UK and Japanese companies are now both forecast to suffer a decline in profits this year, while profits are only expected to grow by around 2% in the US, Europe and emerging markets. Things have been looking worse on this front, not better (at least in the short term).
It is true that analysts are forecasting 8% profit growth in the UK next year and more than 10% in the US, Europe and emerging markets, so this may be part of the explanation. However, Schroders’ economists are forecasting that economic growth in 2020 will be lower than it has been this year, so these look a stretch.
Central banks at the wheel
In reality, the main drivers of stock markets have been central banks.
Near the end of 2018, the market was expecting the US Federal Reserve to raise interest rates twice in 2019. Instead, it has cut them twice, with one further cut still expected before the year is out.
The European Central Bank and Bank of Japan have also joined the “cutting club”.
The Bank of England stands apart in not acting, but may be keeping its powder dry in case it needs to respond to a disorderly Brexit.
As has happened so many times in the past decade, whenever it has seemed that the tide was set to turn against the stock market, central banks have ridden to the rescue. Risk has been squashed.
Can valuations reassure investors?
Long term investors may feel uneasy about this. Questioning the sustainability of the rally based on central bank support, rather than fundamentals, is natural. This is where an analysis of valuations can help, by providing a more dispassionate way to look at things.
Reassuringly for long term investors, while fundamentals may appear shaky, valuations are not giving any warning signals.
Our table below shows how different stock markets stack up across five different valuation indicators (see the end of this article for a brief explanation of each). We also show the 15 year average (median) in brackets for comparison purposes. Figures are shown on a rounded basis and have been shaded dark red if they are more than 10% expensive compared with their 15-year average and dark green if more than 10% cheap, with paler shades for those in between.
How various stock market valuations stack up
With the exception of the cyclically-adjusted price earnings multiple (CAPE), UK and European stock markets are valued pretty close to their 15-year average. If the timeframe is extended to 20 years, they are both cheap on all fronts. Japanese equities are also cheap but our economists are forecasting a fall in Japanese economic output next year, so this cheapness is not without reason. Emerging markets present an interesting proposition. Valuations are cheap but stocks could be buffeted by political manoeuvrings on trade. The US stock market is the only one which gives cause for concern from a valuation standpoint. However, it is also where growth is forecast to be strongest. Reassuringly expensive?
The underlying message is that even though the fundamental backdrop has been miserable and markets have performed exceptionally well this year, valuations remain at pretty reasonable levels. There are plenty of reasons why investors could justifiably feel pessimistic or fearful about the future, but valuations are not one of them.
The pros and cons of stock market valuation measures
When considering stock market valuations, there are many different measures that investors can turn to. Each tells a different story. They all have their benefits and shortcomings so a rounded approach which takes into account their often-conflicting messages is the most likely to bear fruit.
A common valuation measure is the forward price-to-earnings multiple or forward P/E. We divide a stock market’s value or price by the earnings per share of all the companies over the next 12 months. A low number represents better value.
An obvious drawback of this measure is that it is based on forecasts and no one knows what companies will earn in future. Analysts try to estimate this but frequently get it wrong, largely overestimating and making shares seem cheaper than they really are.
This is perhaps an even more common measure. It works similarly to forward P/E but takes the past 12 months’ earnings instead. In contrast to the forward P/E this involves no forecasting. However, the past 12 months may also give a misleading picture.
The cyclically-adjusted price to earnings multiple is another key indicator followed by market watchers, and increasingly so in recent years. It is commonly known as CAPE for short or the Shiller P/E, in deference to the academic who first popularised it, Professor Robert Shiller.
This attempts to overcome the sensitivity that the trailing P/E has to the last 12 months' earnings by instead comparing the price with average earnings over the past 10 years, with those profits adjusted for inflation. This smooths out short-term fluctuations in earnings.
When the Shiller P/E is high, subsequent long term returns are typically poor. One drawback is that it is a dreadful predictor of turning points in markets. The US has been expensively valued on this basis for many years but that has not been any hindrance to it becoming ever more expensive.
The price-to-book multiple compares the price with the book value or net asset value of the stock market. A high value means a company is expensive relative to the value of assets expressed in its accounts. This could be because higher growth is expected in future.
A low value suggests that the market is valuing it at little more (or possibly even less, if the number is below one) than its accounting value. This link with the underlying asset value of the business is one reason why this approach has been popular with investors most focused on valuation, known as value investors.
However, for technology companies or companies in the services sector, which have little in the way of physical assets, it is largely meaningless. Also, differences in accounting standards can lead to significant variations around the world.
The dividend yield, the income paid to investors as a percentage of the price, has been a useful tool to predict future returns. A low yield has been associated with poorer future returns.
However, while this measure still has some use, it has come unstuck over recent decades.
One reason is that “share buybacks” have become an increasingly popular means for companies to return cash to shareholders, as opposed to paying dividends (buying back shares helps push up the share price).
This trend has been most obvious in the US but has also been seen elsewhere. In addition, it fails to account for the large number of high-growth companies that either pay no dividend or a low dividend, instead preferring to re-invest surplus cash in the business to finance future growth.
A few general rules
Investors should beware the temptation to simply compare a valuation metric for one region with that of another. Differences in accounting standards and the makeup of different stock markets mean that some always trade on more expensive valuations than others.
For example, technology stocks are more expensive than some other sectors because of their relatively high growth prospects. A market with sizeable exposure to the technology sector, such as the US, will therefore trade on a more expensive valuation than somewhere like Europe. When assessing value across markets, we need to set a level playing field to overcome this issue.
One way to do this is to assess if each market is more expensive or cheaper than it has been historically.
We have done this in the table above for the valuation metrics set out above, however this information is not to be relied upon and should not be taken as a recommendation to buy/and or sell If you are unsure as to your investments speak to a financial adviser.
Finally, investors should always be mindful that past performance and historic market patterns are not a reliable guide to the future and that your money is at risk, as is this case with any investment.
Issued in the Channel Islands by Cazenove Capital which is part of the Schroders Group and 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 unless otherwise stated.