Valuation is in the eye of the beholder
Equity valuations always appear stretched during crises and whether something is cheap or expensive is usually relative to historical prices
Wed, Jun 03, 2020
Shawn Teow
JUST because equities have rebounded strongly in the face of poor coincident economic data does not mean it is expensive and should be avoided at this juncture. Global equity markets have been on a tear lately. Their meteoric rise from March lows has prompted many calls for a downward turn in equity markets. Global small, mid and large caps (as represented by the MSCI All Country World indices) are all trading at levels that are much higher than their respective long-term averages.
But equity valuations always appear stretched during periods of crises. Simply look back to the Global Financial Crisis, eurozone crisis, China de-leveraging crisis, or even the current debacle we are in - the 12-month forward price to earnings (P/E) or price to book (P/B) valuation multiples are almost always considered too high. These metrics have never been good indicators during inflection points. One reason is that earnings are often never proactively revised ahead of price movements.
We often base our views of whether something is cheap or expensive relative to historical prices. In absolute terms, global equities are now trading at levels where they were nearly a year ago, despite projected earnings falling close to half from what they were. Stating that equities are expensive and should be avoided would be an easy conclusion.
However, looking at P/E alone (especially in an abnormal market environment) may be insufficient. Assets tend to be priced in reference to other competing asset classes. Equities and bonds are no different. Knowing how equities are priced relative to bonds essentially gives investors a better idea of which is the better of the two main asset classes to allocate towards.
LOWER BOND YIELDS MEAN EQUITIES HAVE TO BE PRICED HIGHER
In this case, the excess earnings yield (earnings yield less 10-year US Treasury yield) that equities provide disagrees with what the P/E metric is suggesting. This is because US Treasury bonds in relative terms have appreciated significantly in price. Excess earnings yield is saying that equities are neither cheap nor expensive at these levels as they trade near their 10-year historical average. This is the rough level at which market participants generally agree upon across time in terms of how much equity risk premium is required to hold equities. Even before the pandemic happened, there have been instances when it was more expensive to invest in equities relative to bonds (excess yields below long-term average).
Given that corporate earnings in 2020 is considered a foregone conclusion, it would be reasonable to expect investors to price in where earnings would be one or two years ahead. Consensus estimates currently expect a strong bounce in the global economy, partly stemming from its gradual reopening across the globe, as well as the record levels of fiscal and monetary stimulus injected by central banks and governments. Given the lag effect of fiscal and monetary stimulus, economic and earnings data could reflect a rebound in the coming months. When that happens, perhaps the current run-up in equity valuations on hindsight may be justified.
WHAT IS LIKELY TO DRIVE THIS RECOVERY IN EARNINGS
As investors or market participants, we need to see that the global economic situation is improving. There needs to be a semblance of a recovery. Ultimately, how quickly the global economy will recover depends on how quickly businesses can reopen. We can have a rough gauge of this via the number of unemployment claims made by individuals. Lower unemployment claims at a time when parts of the economy are reopening are indicative and supportive of an economic recovery in the months ahead as individuals return back to work.
Things could be returning back to normal earlier than you think as we move into summer when the coronavirus is thought to be less virulent. Let's use the United States as an example given the large representation it has in global equity indices. US equities (as proxied by the Wilshire 5000 Index) tend to find their bottom around the peak of unemployment claims after a crisis, which also often coincides with the beginning of any market recovery. The equity market rebound from this perspective is certainly not irrational as some market observers might believe.
At the end of the day, we believe earnings are ultimately the biggest factor that matters. We observe that forward earnings across multiple time-frames for global equities have reached a baseline, and negative revisions for earnings appear to have bottomed. Should positive surprises start to come in the quarters ahead, it supports the thesis for further price appreciation for global equities.
COULD THIS BE THE SHORTEST RECESSION EVER?
Given the range of unknowns, it may be too soon to conclude that the worst is over, even as odds suggest that it might be the case. There are still many factors that could derail this market recovery. We may have averted a liquidity crisis in the first part of the year, but a potential corporate solvency crisis could be brewing in the background as we begin to see bankruptcies occurring in some parts of world. No one can say for sure.
However, I believe that governments and central banks worldwide have shown willingness to set aside fiscal and monetary prudence until they begin to see a sustained recovery in their respective economies. Furthermore, politically there is a lot riding on 2020. The world's biggest economy will have its presidential election in November, and there will be a lot of pressure to keep the liquidity spigots running at least until after it.
Also, the market turmoil in February and March was sparked by a health crisis. It is logical to expect it to be resolved with a medical solution. There's a lot of money, research effort and political capital invested in finding a vaccine across the world. This gives me hope that we will find a solution in the near future.
By then, equity markets could well be on their way up. Timing the market is nearly impossible. In this news-driven market environment, I maintain my belief that staying invested via a regular savings plan is the best way for retail investors to mitigate risk and participate in any potential upside ahead.
The writer is the senior unit trust analyst of the Research & Portfolio Management team at FSMOne.com. FSMOne.com is the Business-to-Consumer (B2C) division of iFAST Financial Pte Ltd., the Singapore subsidiary of SGX Mainboard-listed iFAST Corporation Ltd.
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