Valuations: An important part of the puzzle

In this cycle valuations have been, so far, the dog that did not bark. Globally, the median sector price/book multiple has risen from the trough of 2008 to a new peak. Such an expansion in market valuations is similar to that seen in the 1980-1987 period. Between 2012 and today we have come full circle in terms of tactical asset allocation. Earlier, we could not understand why investors were so uninterested in adding risk to portfolios despite such high expected returns in equities. Now, equity valuations suggest only modest long-term returns are on offer and there is greater prospect of short-term disappointment. It is however proving equally difficult to attract investors’ interest in this signal for caution. Perhaps the metaphorical – and silent – valuation dog knows the psychology of the current marginal investor rather too well.

Exhibit 1: Median sector price/book premium to 35-year average

In Exhibit 1 we show the median price/book premium to the 35-year average for the sectors in the Datastream world non-financials index. This shows that price/book valuations across sectors are at an all-time high since the 1980s. The picture is very similar whether we consider single regions such as the US or Europe, developed or emerging markets. The rise in the last 18 months has been especially marked as growth in market value has by far eclipsed growth in book value.

Exhibit 2: Correlation between price/book multiples and 12m forward price performance

We acknowledge there is in fact only a relatively weak negative correlation between price/book valuations and short-term share price performance, as shown in Exhibit 2. Nevertheless, an important reason for caution is that all of the major market drawdowns since the 1980s have occurred when price/book multiples are at a significant premium to long-term averages, as they are now.

Furthermore, while some may consider this the most unloved equity rally in living memory, we would also highlight that the expansion of valuations is as strong as during the 1980-1987 period. This does not necessarily imply a correction as strong as October 1987 is due. The data instead suggest to us an increased but still low probability of that particular outcome.

Faced with this anomalous situation for valuations, we have to consider if we are looking at an artefact of the data which will be resolved with hindsight or whether we should be more concerned. In this respect, it is important in our view to acknowledge that opposite ends of the opinion spectrum are more eye-catching than the full range of possibilities. Namely, it is not just a case of ‘this time is different’ or ‘market crash imminent’. There are a range of possibilities, including a period of merely sub-par performance as corporate profits catch up with share prices.

It has been argued the situation for equities is different this time due to the unprecedented level of central bank intervention in financial markets globally. In some regards, Western economies have borrowed some of the state-backed market stabilisation techniques used in emerging markets. The ECB’s QE policies which tamed the peripheral debt crisis are arguably the most recent example.

(Such policies were frowned upon at one point – not because they did not work in the short-term but were likely to lead to misallocation of capital and lost productivity growth in the long-run. Interestingly, there is now a slow productivity growth puzzle in both the US and UK.)

We would argue this is a valid point but now reflects, at best, investing while looking out of the passenger window, if not the rear view mirror. The Fed has fired the starting gun on balance sheet reduction and the ECB is tapering QE during 2018. In addition, US short-term interest rates are moving steadily higher and will continue to do so during 2018, even if for now this is being ignored by risk assets. The closing of output gaps does now appear to be having an impact on central bank policymakers, notably in the UK, despite well-founded fears of choking growth by tightening policy too quickly.

With so many years having elapsed under the regime of ultra-loose monetary policy, it is easy to forget that capital markets are theoretically a rationing mechanism, where scarce capital is allocated to economic entities offering the best prospects for returns. In this vein, we believe that we have passed the point where higher economic growth is beneficial to equity ratings as there is, based on aggregate valuation measures at least, relatively little remaining risk premium embedded in market prices.

Faster economic growth and higher corporate investment coupled with tighter monetary policy (or quantitative tightening) should imply higher expected returns for investors. This process could be relatively benign if rising corporate profits and rising expected returns offset and markets trade sideways for a period. This is in our view the outcome desired by monetary policymakers; it is also a scenario which, while not a disaster, should not be especially appealing to equity investors.