Valuation puzzle

Equities are expensive. It’s difficult to argue against this. But does this also mean that markets will fall sharply? Assuming that there are plenty of other factors that could drag equity prices lower, the high valuation alone is probably not enough reason for a new market correction.

Granted, the price-earnings ratio is high, in some cases even historically high. The Shiller PE, which looks at corporate earnings development over the last ten years, is over 30 in the US, which happens rarely. And the graph shows that Warren Buffett’s favorite valuation indicator – total market capitalization as a percentage of GDP – also indicates historically high equity valuations.

 

Correction looming?

Are the high equity valuations the harbinger of a correction? Given the high degree of uncertainty surrounding the outbreak of Covid-19 and the recovery of the global economy and corporate earnings, the odds of a correction at any given time are elevated. However, it’s less likely that current valuations would be the direct cause for this. More probable is that when a catalyst does occur, for example in the form of a – temporary – downturn in the economic recovery, investors will be quick to use valuations as an argument to sell equities.

What’s more, valuation is a relative concept. Government bonds, for example, are currently a lot more expensive. And with the recent fall in corporate bond spreads, equities have also become somewhat more attractive in relative terms. Aggressive stimulus policies of both governments and central banks play a major role here.

As markets are flooded with free money, some of which finds its way to equity markets. In Japan, the central bank is even buying equities directly in the form of ETFs. If we dare to suppose that the accommodative policies of central banks drive up asset prices, then equities should perhaps be even more expensive.

Close to the exit

So should we just accept valuation entirely for what it is? Well, given current market sentiment, yes. If high levels of stimulus continue (we’re currently waiting for a new plan from the US), and macroeconomic figures continue to improve, investors will continue to focus on the ‘flow of good news’.

It is both a strength and a weakness of equity markets that current developments are sometimes priced in indefinitely. You need a catalyst to reverse investor sentiment.

For sure, there is no shortage of possible catalysts. The low-hanging fruit in the recovery has been harvested, labor markets remain weak and the run-up to US elections may also lead to greater volatility on equity markets. That’s why we prefer to huddle fairly close to the exit; to ensure that when sentiment turns, and valuation is used as a stick to beat the dog, we are not trampled underfoot by other investors who are also all charging for the door at the same time.

This blog was originally posted on robeco.com https://www.robeco.com/en/insights/graph-of-the-week.html

 

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