World equity markets – bubble territory?

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There’s currently a lot of commentary around the valuation (or more accurately, the overvaluation) of world equity markets.  Some argue markets have run too far and are in irrational bubble territory.  Another view is that despite the S&P500 having soared 193% since the grim days of early 2009, we still have to look at market fundamentals.  And these are far from stretched.

Wednesday, August 6th 2014, 10:27AM 2 Comments

by Pathfinder Asset Management

The recent run by equity markets has been unbelievable compared to previous recoveries.  From 1997 to 2000 the S&P500 charged ahead by 106%, only to collapse by 49% over the following 2 years.  In the 5 years to October 2007 it rose strongly (+101%) only to fall 57% to its 2009 trough.  So a run skywards of 193% to new all-time highs must send us into overvalued territory, right?

Based on a range of measures we’d say no, world market valuations are above fair value but not stretched.   We like four simple market valuation metrics which over time consistently and objectively help form a view of hype vs fair value.  These indicators are:

1. A simple long run trend analysis
2. Tobins Q (comparing the market cap of all listed companies with the total replacement cost of their assets)
3. Warren Buffet’s favourite valuation metric (market cap as a percentage of GDP)
4. Forward P/E  ratios compared to the 5 year average

One of the critical decisions with market valuations is not the measure you use but the starting point you measure from.  Some go back a long way – for example the highly regarded Shiller Cyclically Adjusted P/E  ratio (also known as the CAPE) uses a start date of 1880.  We question the relevance of going back that far – companies are very different beasts compared to 30, 50 or 100 years ago.  We prefer a more recent data set starting in June 1987 for 3 reasons: (1) this is roughly when markets became more globalised, heavily traded and liquid (2) this is after the last bout of out of control inflation and (3) this start date predates the first of the modern stock market crashes in October 1987.

So armed with our June 1987 start date what do the indicators tell us?  Firstly we are nowhere near the overvaluation levels of the late 1990s.  Although the market is higher than at any point in the last decade, we are far from bubble territory.   When past markets were at the same level as now the following two years returned an average of 6% p.a. (although with considerable variation around this average).

A key driver for share price growth is earnings growth.  If company earnings grow and market P/E valuations remain stable, then share prices must go up.  Over the next 2 years analyst expectations are for robust S&P500 earnings growth of 8.6% (one year ahead) and 11.5% (the following year).  Based on these earnings estimates if the S&P500 P/E  ratio remains the same we will see shares return 10% p.a. from earnings growth alone. 

At current price levels this implies a market P/E in two years of 15.0 and in 3 years 13.5.  That is, in historical terms, good value. In fact the market’s current P/E of 16.7 is pretty much on its 5 year average (compared to March 2000 when the market P/E was 25).

If forward valuations are not unreasonable, can global markets still fall?  Yes - even when markets appear fairly valued they can become cheaper.  Events may discourage risk taking.  Earnings may be hit. Confidence may be lost.  Perhaps the biggest fears centre round the Fed changing monetary policy to remove QE inspired liquidity out of the system causing interest rate to rise dramatically and driving an equity sell off (as equities re-price relative to interest rates).  Low interest rates have certainly been beneficial for corporates – cash balances on S&P500 corporate balance sheets are extremely high at about US$1.3 trillion or over 10% of market capitalisation.  Expect to see plenty more share buybacks and M&A activity.  We don’t expect a meltdown here -  the withdrawal of QE first requires robust economic growth which will help earnings.  But a Fed miscalculation is always possible. 

Other major economies could drag the world down – question marks remain around China’s property market and Europe’s banking system.  Geopolitical risks are also a threat to markets – the Middle East and Ukraine are particularly problematic at the moment. 

What does this mean for NZ investors? 

Let’s be clear, the S&P500 tells us nothing about the valuation of the NZ share market.  We are a small market (less than 0.1% of global market capitalisation) that can be moved by events of little relevance to global share markets - like dairy price auctions and local elections.   

In relation to international stocks, we see an opportunity for NZ investors.  Firstly, while recognising risks, we expect US stock price growth over the coming couple of years.  Secondly, and most importantly, we’d encourage NZ investors to think about their currency hedging.  A partial hedge (say 50%) should offer some protection if global markets fall.    This is because the NZ dollar tends to fall when world equity markets fall – and the NZ dollar is currently at very elevated levels.  If world markets fall, the NZ dollar falling off its peak should provide a buffer as it did in the 2008 market meltdown.

So to summarise, investors should not capitulate to the voices saying world markets are overvalued – that argument is largely based on the incredibly strong run in prices since early 2009.  But a strong run is not in itself proof of market overvaluation – while fundamentals are elevated they are not excessive.  Returns in the 6% to 10% per annum range over the next 2 years are entirely possible for the S&P500.  Finally consider using the high NZ dollar to invest offshore and (through only partially hedging) retain a potential buffer should markets retreat.

John Berry and Paul Brownsey
Executive Directors
Pathfinder Asset Management Limited

Pathfinder is a fund manager and does not give financial advice. Seek professional investment and tax advice before making investment decisions.

Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz

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