17 Dec 2019
Major bear markets have historically occurred when there has either been recession or extreme over valuation in at least one asset class. The TMT blow up, which occurred in the early 2000’s, was as a result of over valuation in one part of the market, primarily technology. In 2008 property and parts of the credit market were overvalued which, when combined with issues in the banking system, resulted in a loss of confidence and severe market setback.
The current bull market is one of the longest in history, but the bull markets from 1949 and December 1987 were approximately two years longer than the current upturn and produced returns in excess of the current bull run. Whilst this economic cycle has been longer than any other in the States, it has not been accompanied by excesses in the real economy and policy makers, both at the Fed and government levels, remain focused on avoiding recession and ensuring that the current upswing continues.
When looking at market multiples, many markets appear expensive on cyclically adjusted PE ratios and have done so for many years. The forward PE on US earnings is around one point higher than the 1996 average, but the discount rate applied to the earnings stream is considerably lower than the average for this period. Looking at historical 10-year US equity returns from current forward PE ratios, returns have been clustered within the 6% to 8% p.a. bracket. For both Europe and the UK, forward PE ratios are below the 1996 average, and if corporates can deliver the expected increases in profits, forecasts for 2020 market valuations don’t look expensive for developed markets in the West. Emerging markets have also de-rated with price to book ratios below long-term averages at 1.6x versus the average of 1.8x and again, 10 year returns to investors at this level of valuation have been attractive. The typical reason for poor returns of emerging markets is US currency strength, and with the Fed in easing mode, neither Asia nor the emerging world looks likely to see problems from being forced to tighten domestic liquidity conditions. Japan is also trading significantly below its 1996 average PE.
In summary, current equity valuations are supportive of markets when looked at in absolute terms versus their post 1996 multiples, especially in the context of the future discount rate applied to corporate earnings, which is now at or close to all-time lows. Earnings forecasts for next year for major markets may well be too optimistic, but this year, despite a significant pullback in expectations for corporate earnings, risk assets have still delivered strong returns. Expectations for corporate earnings and profits growth in 2020 are likely to be optimistic and an improvement from the 2019 outturn could well be enough to deliver positive returns for investors next year.
Graham O'Neill, Senior Investment Consultant, RSMR
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