It’s not like the world is without uncertainty. Geopolitical uncertainty — as measured by a group of Fed researchers — has rarely been higher in the past forty years.
And as we’ve discussed, most dimensions of economic uncertainty are sky high:
But stock markets don’t appear to give a hoot.
Of course, a higher S&P 500 index doesn’t necessarily mean skimpier risk premia. It’s perfectly possible that the market could be discounting an ever-rosier future, and doing so with ever-great risk premia — and that this combination results in higher stock prices.
While possible, this is also unknowable. Because despite being central to finance theory and practice, the equity risk premia is also based largely on vibes.
Rather than dive down this particular rabbit hole we’re going to throw you a few high level valuation charts. No rocket science here, just painting the scene for those who don’t follow this stuff obsessively.
One common way to assess the valuation of stocks is the price/earnings ratio — the index market capitalisation divided by a year’s earnings. Regardless of the year, last year’s earnings are always tricky — one off write-downs, special situations that are bound never to be repeated, etc. But next year is always more straightforward. And anyway, financial markets are forward-looking, so let’s take the bottom-up analyst consensus for next year’s earnings and compare it to current prices:
PE multiples for the MSCI regional markets are each in the top tertile of their own 20 year histories. Punchy? Not compared to the US market, which trades in the top three percentile of its range.
How about price-to-book — the ratio between all the index constituents net asset values and their stock prices? Analysts in some sectors use the metric, but as market-wide valuation measure it is rarely referred to.
Which is good, because it flags US stocks as crazy rich:
Of course, US companies have been historically much better at growing their earnings than companies in other markets. If they can continue to do so it makes sense that they should trade at higher multiples.
Whether they can continue to grow faster, and how much more this is worth is the perpetual question haunting asset allocators. If you have a view, you can get rich/ poor (come back and delete as applicable in a few years time) trading this view, or — if that sounds too high-stakes — maybe just tell us about your view in the comments below.
How do longer-term metrics look? While we’ve had not altogether kind words for the Shiller cyclically-adjusted price/earnings ratio in the past, it’s worth checking in on CAPE:
As a reminder, the Shiller CAPE takes the index price and divides it by the average of the last ten years’ inflation-adjusted earnings. The measure’s usefulness relies on: 1) a business cycle existing; 2) earnings being sensitive to the business cycle; 3) there being some reasonably steady trend in overall earnings over multiple business cycles; and; 4) that by comparing prices to the averaging the last ten years’ earnings, medium investors will get a better sense of fair value than shorter-term measures.
People can — and do — argue each of these points. What is unarguable is that it hasn’t been the worst predictor of decadal real returns over the last forty years:
Just because investors have never before realised positive 10-year real returns when investing at CAPE above 37.3x, doesn’t mean they can’t. This time may be different.
But there’s a decent argument that stock valuation metrics are all bumf — a thing that we can calculate and chart, but incidental to subsequent market performance.
Put another way, given that most stocks end up losing money, all that really matters is buying the ones that sustainably grow their earnings. Over-paying or under-paying might impact your short run wealth, but even over ten year periods the thing that has mattered most has been not the price you paid, but the earnings growth that your stock picks delivered.
Take a look at this chart that shows how annualised changes in expected earnings per share over the past decade (on the horizontal axis) has related to annualised returns in local currency for regional-sector baskets of stocks. The size of the bubble represents their weight in the MSCI ACWI index:
Top right we see that US tech has delivered the strongest returns to investors. It also delivered the highest level of expected earnings growth. On the far left are European telcos, which at an index level saw expected earnings shrink over the period.
So should we worry about the lack of risk premia seemingly priced into stocks, in an environment that is seemingly full of uncertainty?
We leave the last word to Warren Buffett, disciple of Benjamin Graham and OG value investor, writing in his 2000 annual report on his approach to valuation:
Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component — usually a plus, sometimes a minus — in the value equation
That’s told us.
