Are equities really overvalued?

Are equities really overvalued?

12 February 2021

5 minute read

As many equity markets hit record highs, investors may be hesitant to invest. However, with bond yields still relatively low, there remains good reason to invest in equities for the long term.

Key points:

  • Many equity markets have hit highs this year, buoyed by a new US president, anticipated larger American stimulus and economic recovery hopes on the back of vaccine rollouts
  • Traditional price to earnings (P/E) ratios may be poor valuation metrics at a time of very low bond yields
  • The equity risk premium seems a preferable metric for asset allocators and suggests that equities are fairly valued.
  • Increasing the cyclicality of equity portfolios has attractions as more investors mull “reflation” trades
  • A strong preference for “quality” companies and exposure to industrials appeals.

Going into this year, financial markets seemed priced for economic recovery, strong earnings growth and continued fiscal and monetary support. That said, demanding valuations often get in the way, leaving many investors hesitant. While traditional valuation metrics might appear unappealing, their relevance looks limited in the current, low interest rate, environment.

Rich valuations?

On a price-to-forward earnings ratio (P/E) basis, the most widely used valuation metric, global equities have rarely appeared richer. Indeed, the MSCI All Country index trades at around 20 times the earnings expected by the consensus over the next twelve months.

Looking at monthly data from 1988, this level is in the 90th percentile of all observations. In other words, global equities have only been more expensive for 10% of the time in the last 33 years. At face value, there seems little incentive for investors to buy into the market at this stage and many prefer to “wait for a better entry point”.

The limits of P/E ratios

While P/E ratios globally seem elevated, arguably they offer little insight. Indeed, there appear to be three main flaws with relying solely on the ratio to inform investment decisions.

First, as an aggregate measure encompassing perhaps thousands of constituents, index-level P/Es are influenced by the composition of the market they represent. As such, comparing the ratio across decades fails to account for the significant constituent changes in indices over that time. Furthermore, the emergence of many large, higher-growth technology companies this century seems to have further distorted historical comparisons.

Another issue with P/E ratios is that they ignore elements that can be crucial to assessing the attractiveness of any investment. These elements include long-term growth prospects, the cost of capital and the opportunity costs arising from making any investment decision.

Finally, and maybe most importantly, P/E ratios aren’t usually a good predictor of returns. Valuations are generally mean-reverting and arguably are more likely to contract than to expand from current levels. Yet, this does not necessarily mean that equities are headed for a correction. Indeed, earnings (and dividends) tend to be a much more important driver of returns. As long as earnings can outgrow contracting multiples, then positive returns should follow.

Alternative metric

Because P/E ratios aren’t reliable valuation tools, especially in a period of extremely low interest rates, alternative metrics may be needed.

When evaluating specific stocks, return on invested capital (ROIC) is often more preferable, as it successfully overcomes the effect of capital structure on companies’ performance. In addition, when measured against the weighted average cost of capital (WACC) – which de facto includes the impact of changes in interest rates – ROIC allows investors to assess the business’ ability to generate value for shareholders.

Equities offer value versus bonds

For broader indices, and because ROIC may be less relevant for certain sectors, the equity risk premium (ERP), or the difference between expected earnings yield (the inverse of the forward P/E ratio) and the yield on risk-free instruments such as Treasuries, may be preferable. The ERP is likely to be the most relevant for asset allocators as they are required to choose whether to invest in stocks or bonds.

On the back of Democrat victories at the US presidential election and subsequent Senate runoffs in Georgia, the odds of significantly higher fiscal stimulus have risen. As a result, the yield on 10-year Treasuries has risen steadily, recently breaking above 1%.

The increased Treasuries yield has pushed the ERP below 350 basis points, its lowest level since mid-2018. However, based on this metric, equities remain much more attractive than risk-free bonds and much less expensive than they were in the early 2000s.

Beware of rising 10-year yields on inflation concerns

The ERP is in the middle of its historical range in percentile terms. This suggests that equities can still generate positive annualised returns over the next five years.

By itself, a rising 10-year bond yield isn’t necessarily bad for equities. As long as higher rates are the result of more growth, both in economic activity and companies’ profits, equities may still perform well.

Timing is important too, as it usually takes at least a few quarters for earnings growth to emerge. If the 10-year bond yield rises too soon, and too fast ahead of the improvement in earnings, then the ERP would likely contract to dangerous levels.

Remain invested

In this context, being invested seems the best course of action. As the idea of a “reflation” trade is gaining traction among investors, slightly hiking the cyclicality of equity portfolios has attractions. A strong preference for “quality” (implying an attractive ROIC) over any other factor appeals. From a sector perspective, this would translate into increased exposure to the industrials complex, moving away from staples and other bond proxies.

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