The start of 2018 has been volatile for stockmarkets. Duncan Lamont, Head of Research at Schroders, explains how it has shifted valuations.
Global stockmarkets have just suffered their first quarterly decline in two years. All major developed markets were in the red.
UK equities shed over 7% while Japan was down almost 5%. Even the previously untouchable US inflicted losses on investors.
Only emerging markets started the year with a spring in their step. Since the end of 2016, they have returned around 40% in US dollar terms, almost double the haul for developed markets over the same period.
As winter draws to a close in the northern hemisphere, households are engaging in their annual spring clean. Given recent market moves, now is a good time to do the same with your equity portfolio.
As we have argued previously, valuations can be a very useful tool when thinking about long-term investment strategy. They are next to useless at predicting short-term market movements but for the medium to longer term investor they are an essential part of the toolkit.
To continue the spring clean metaphor, redecorating your house to be constantly “on trend” is an expensive and time consuming task. Trends are so fickle that you may get it wrong anyway.
But valuations are like investing in classic design. The outcome may not always be flavour of the month but it is likely have a longer shelf-life than the latest fad.
Investors nursing losses from the first quarter of the year can draw some comfort that valuations are now looking less extended than three months ago. This suggests a more favourable environment for the long-term investor. However, we’re not out of the woods yet. Most markets, especially the dominant US (which is over 50% of major global equity benchmarks), continue to be expensively valued in at least some respects.
The table below shows a number of valuation indicators compared with their average (median) of the past 15 years, across five different regional equity markets. A description of each valuation indicator is provided at the end of this document. 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.
The US continues to look very expensive on almost all measures. But a combination of positive economic momentum and fiscal stimulus could continue to support returns in the near term.
In contrast, Europe looks fairly valued. It is neither especially cheap nor expensive on any valuation indicator other than CAPE (explained below), which looks on the high side. However even here, the current CAPE is only in line with its 20-year or longer term average so this is not unduly concerning. When considered alongside the robust growth story in Europe, this market continues to have some appeal.
The UK is a mixed bag. Share prices look on the slightly expensive side, though not excessively so, when compared to earnings but cheap compared to book value or dividends. The UK’s high dividend yield has always been part of its appeal to some investors. Income of more than 4% clearly has its attractions in a low-yielding world.
However, a note of caution. UK-listed companies have been struggling to afford those dividends. They have been forced to pay out over two thirds of their recent earnings to do so, a much higher proportion than normal. Analysts are also forecasting the UK to have the worst prospects for dividend growth of all those in our analysis over the next two to three years. There may be value but it is not a time to be an indiscriminate buyer.
Emerging markets continue to look reasonably valued relative to developed markets but their strong performance has pushed prices up and the case is weaker than before.
Japan looks the most obvious buy from a valuation perspective but the export-oriented nature of the stockmarket means that it is also more exposed to the rising tide of protectionism and has a relatively weak outlook for earnings growth as a result.
So what would my valuation-based spring clean look like? It would suggest reallocating away from the US, in favour of emerging markets, Japan and Europe. If income is a priority then selective buying of the UK could also make sense. However, none of these are without risk. Markets that are cheaper are so for a reason. In these instances, maintaining a diversified exposure rather than betting it all on that daring new wallpaper you’ve been eyeing up should allow you to sleep more easily at night.
How to value stockmarkets
When considering equity 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 stockmarket’s value or price by the aggregate earnings per share of all the companies over the next 12 months. A low number represents better value.
An obvious drawback is that 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.
This is particularly true if earnings have slumped but are expected to rebound. For example, UK equities are very expensive on this measure at present, partly because of past commodity price declines and the UK market’s large commodity exposure.
However, commodity prices have rebounded amid an expectation of a profit rise this year. The UK therefore looks very expensive on a trailing P/E basis but less so on a forward P/E basis.
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 month’s 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 stockmarket. 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 stockmarkets 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.
Finally, investors should always be mindful that past performance and historic market patterns are not a reliable guide to the future.
This article has first been published on schroders.com.