Valuations – might it be different this time?
Investors have been fretting about valuations for some time, and the recent wobbles in markets seem to endorse the fragility of current equity pricing.
- Stock markets look increasingly overvalued
- Some have argued that investors should reappraise how they value equities in the light of lower-for-longer interest rates
- While current valuations may be sustainable, it is difficult to see a catalyst for them to rise higher
On basic price to earnings measures, valuations looking high. Goldman Sachs research suggests the forward P/E multiple of the S&P 500 is up by 80% since 2011. Some US technology stocks are trading at levels not seen since the financial crisis and markets seem surprisingly unbothered by the political turmoil in the White House.
However, some suggest that if interest rates are likely to be structurally lower for some time, current valuations can be supported. Comparisons with historic multiples are redundant because we have never seen this type of environment before. For example, a recent paper from BlackRock’s Investment Institute, called on investors to rethink asset valuations. It said: “The earnings yield of US equities (earnings per share divided by the share price, or the inverse of the price-to-earnings ratio) gauges the attractiveness of equities versus bond yields. This measure puts US equity valuations in the richest quartile of their history. Yet the earnings yield still looks attractive versus bond yields. Also we see less reason to expect equity valuation metrics to fall back to historical means in a world of lower rates.”
“That said, if valuations can stay the same and investors can just collect their dividends, they will be doing better than in cash.”
It argued that the problem with looking at historic valuation measures was that investors might conclude equities were over-valued, exit into cash and then be stung by inflation. Longer-dated bond yields have been falling as fixed income markets have increasingly priced in lower rates over the long term.
However, this is an uneasy balance. Suggesting that valuations can be sustained at their current level is not the same as suggesting they can make significant progress from here. That said, if valuations can stay the same and investors can just collect their dividends, they will be doing better than in cash.
The big risk is that central banks raise interest rates by more than the expected 1%-2%, longer dated bond yields rise and equity valuations fall back significant. A big increase in inflation would put pressure on both bonds and equities.
As such, it is difficult to argue that there aren’t vulnerabilities in equity markets, but for the time being it is difficult to find a catalyst for them to be realised. Yes, the low interest rate environment changes the comparative value of equities over bonds. However, it doesn’t mean that investors can rest easy in their equity holdings.