Expensive valuations are a regular reason for investors to push back on investing in equities. The recovery of U.S. equities in the past six months from its March low was spectacular. The S&P 500 jumped by 60% from trough to its recent September peak, while the NASDAQ index rebounded by 75%. Both indices hit their respective record highs despite the fact that the COVID-19 pandemic is still ravaging the global economy and corporate earnings. Global gross domestic product (GDP) and corporate earnings are not expected to return to the pre-pandemic level until late 2021, or even 2022. This divergence of economic and corporate fundamentals and the performance of the equity market prompted the question on valuations and the sustainability of this rally.
Indeed, if we look at one of the most popular valuation metrics, the forward price to earnings ratio (P/E), most equity markets look expensive. As shown in Exhibit 1, all the major indices are currently trading at a P/E multiple above their 15-year average. In many cases, such as the S&P 500, MSCI APAC ex-Japan and MSCI emerging market indices, their P/E ratios are at the top of that range. Unsurprisingly, the global earnings recession meant that the denominators (earnings) of these P/E ratios are going to be low and push up the ratios. If earnings continue to grow into late 2021, and 2022, then the current P/E multiples would look more reasonable. Admittedly, this could imply that the potential upside to U.S. equities is more constrained for the time being.
The P/E ratio is not the only valuation metric to consider. The bottom half of Exhibit 1 shows the price-to-book ratios of the same markets. This is where many markets are showing more attractive valuation. The U.S. is the only market that looks expensive by this measure. Europe, Asia and emerging markets are in line with their 15-year averages. A number of ASEAN markets are currently trading below this average, or even at the bottom of their 15-year range (Malaysia, Philippines and Singapore). It is also worth remembering that despite the record high of S&P 500 and NASDAQ indices reached in early September, many European and Asian markets have yet to fully recover from the fall in March. This reflects that the idea of equities being expensive is more applicable to the U.S. and less of a problem of other markets.
The high valuations of the U.S. stock indices are also driven by the large weighting of the technology sector. Technology has been a significant component of the U.S. equity rally of the past six months. Traditionally they have higher P/E multiples and this rally has pushed that up even further. This implies there are still sectors and companies in the U.S. that are trading at more reasonable P/E multiples but need a catalyst, such as the development of a vaccine, to attract investors’ attention.
It is also worth considering equities’ valuation relative to other assets. With risk-free interest rates at such a low level due to aggressive central bank actions, bond prices have also surged across the fixed income asset class. The difference between corporate bond yields have fallen due to lower risk-free rates and credit spread compression, and now closer to dividend yields. Another way to look at relative valuation is through earnings yields, which is essentially the inverse of a stock’s P/E ratio. As a stock’s P/E multiple rises, its earnings yield falls. A lower risk-free rate, and a lower discount rate, would also imply future cash flow to be more valuable. With S&P 500 forward P/E at 22.5 times, this implies an earnings yields of 4.4%. Compared with the yield of 2.4% for Baa-rated corporate bonds, investors could still prefer equities over fixed income.
EXHIBIT 1: GLOBAL VALUATIONS
Questioning valuations is, in itself, a positive signal of investors not suffering from irrational exuberance. The corporate earnings outlook is still highly dependent on how the pandemic unfolds in coming quarters, as well as other variables, such as the outcome of the U.S. elections and the development of U.S.-China economic relationship. That said, it is important for investors to differentiate that valuations are not equally stretched across all markets, and are relative to other asset classes. For example, valuations are more reasonable in markets, such as Europe and ASEAN, which have lagged in the equity market rally in the past six months. A lack of a dominant tech component in their benchmark indices partly explained this lagging performance. They could benefit from a global economic recovery when a medical solution is available to contain the pandemic.
Even as the timing of these medical solutions are uncertain, investors should not avoid investing in equities completely, especially when government bonds are suffering from extreme valuations. Diversification by geography and sector can help investors to build a stronger portfolio for the long term and ride on the next stage of the global economic recovery.