Over or under? An examination of US equity valuation levels

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Victor von Reiche, Portfolio Manager, Citadel

There is a fair degree of scepticism regarding current market valuations in the United States (US) judging by commentary from prominent market watchers, asset managers and financial media outlets.

This is not unexpected.

US equities have been in a very strong bull market since the lows reached in February 2009 following the Global Financial Crisis. Scrutinising records since 1940, we can see that this performance now matches the longest sequence of consecutive positive annual returns – nine in total.

In addition, equity markets across the globe provided double-digit returns in 2017 with record low levels of volatility –unprecedented for risk assets, and clearly not sustainable.

A number of risk factors have already come to the fore in 2018 as evidenced by a sharp spike in the level of volatility – the so-called VIX index, a popular fear gauge earlier in the year.

US economic data in January showed long-awaited wage inflation returning, which has heightened fears of a more hawkish US Federal Reserve stance. When viewed in isolation, raising interest rates is problematic for equities for a few reasons: it increases the opportunity cost, as well as the required rate of return for equites; and it slows economic growth, which leads to lower corporate earnings growth and profitability.

Further complicating the picture is US protectionist rhetoric and trade war brinkmanship, which continues to weigh on investor sentiment and is likely to impact global growth and corporate profitability.

Quantitative tightening, which will see the Fed shrinking its balance sheet and removing liquidity from the market, presents a headwind. Fears of a possible recession have also increased as the yield curve has flattened this year.

In addition to these systemic risk factors, there are pockets of overvaluation today which also pose some risk, such as companies with business models which are viewed as disruptive, for example Tesla and Netflix.

Risk also arises in parts of the market where some companies have indiscriminately bought back shares using cheap debt, and thereby gearing their balance sheets without any real value creation. An environment in which interest rates surprise to the upside might expose these companies.

Traditional valuation metrics which generally inform opinions around market valuations such as the Shiller PE ratio (which shows inflation-adjusted earnings over the past 10 years), show the SP500 index to be trading at an elevated level, only just below that reached during the tech bubble. A number of forward-looking valuation multiples, specifically when viewed over the past decade, show similar levels of overvaluation. Other simplified metrics and ratios, for example total market value expressed as a percentage of GDP or elevated index profit margin levels, again point to reason for caution.

Source: (http://www.multpl.com/shiller-pe/)

This, however, does not provide a complete picture. Equity indices can and do change drastically over time to reflect the prevailing environment. A decade ago the SP500 was dominated by oil & gas, financial, as well as industrial conglomerates. Now, however, tech companies account for most of the top 10 stocks by market cap. These companies grow faster as they become bigger and generate structurally higher margins, requiring little tangible capital to grow, which again can justify higher valuation multiples.

Valuation metrics also don’t account for prevailing interest rates. All other things being equal, higher valuation multiples are justified in lower interest rate environments and vice versa. This is significant, as evidenced by a steady fall in US bond rates, which peaked in the early 1980s mainly due to lower nominal GDP growth.

Taking interest rates into account provides a fundamentally different picture. The absolute vs relative valuation graph illustrates this by comparing the absolute earnings yield (the inverse of the PE ratio for the SP500) to the relative earnings yield (which nets off core inflation and bond yields from the calculated earnings yield). Based on this analysis, the market is expensive on an absolute earnings yield basis (it has only been more expensive 22% of the time), while on a relative earnings yield the market is on the right side of fair value (it has been more expensive 58% of the time).

On this basis, US equity valuation levels based on current bond yields and core inflation look reasonable, and not as extreme as a Shiller PE ratio or other forward-looking multiples would imply.

Source: Bloomberg

The past few years have been characterised by low real growth, low inflation and higher-than-average equity risk premiums. This has directly impacted earnings growth, which has slowed markedly. While bond yields have continued to fall, higher equity risk premiums have ensured that discount rates have not been the main reason for raising equity levels per se. What has sustained US markets in recent years has been the record amount of cash returned to shareholders in the form of dividends and share buy-backs. Effective cash yields in excess of 4% have been attractive when compared with bond yields, which has provided further support to markets.

Source: Bloomberg

To see if US equity markets are expensive, we used an intrinsic valuation framework to determine the fair value of the index by discounting expected cash flows returned to shareholders via dividends and share buy-backs by an appropriate discount rate (incorporating a risk-free rate and equity risk premium). The discount rate assumed was consistent with growth and inflation assumptions specifically for an inflationary, high growth and base case scenario. Current consensus earnings growth estimates by analysts reflect 7% p.a. over the next five years.

Inflation scenario Growth scenario Base case
Description Higher inflation (3%) results in mixed impact on earnings growth, higher ERP (equity risk premium) & T-bond rates) Higher real growth rate, translates into higher earnings growth for US companies, higher T-bonds rates and equity risk premiums drift back to pre-2008 levels Inflation returns (but stays between 2%-2.5%) and real growth in the economy rises moderately, resulting in  higher treasury bond rates with proportionate increase in earnings growth
T-bond rate 4.0% 4.0% 3.5%
Equity risk premium (ERP) 6.0 % (high end of spectrum) 4.5% 5%
Earnings growth –next 5 yrs. 5-7% 8%-10% 7%
Fair value index 1960-2133 2979-3244 2610
Current level 2816 2816 2816
% Over (+)/ Undervalued (-) +43% / +32% -5% /-13% +8%

 

This framework does not suggest extreme under- or overvaluation at current market levels. Although a number of risks remain which could impact markets, valuation risk is not at the top of that list at the moment.

In conclusion, when macro-economic fundamentals change, markets take time to adjust, and this translates into market volatility, which has been in evidence over the first half of 2018. While most market participants focus on specific numbers in isolation – inflation, interest rates, US 10-year bond yields, GDP growth – when determining the relative attractiveness of equities, in reality it is the complex interaction of a number of these inter-dependant variables which dictates value.

Based on expectations of inflation, real growth as well as risk, it is possible to determine a fair value for an index. It is possible that stocks could actually rise even if bond yields increase, particularly if higher rates are precipitated by a strong economy, i.e. higher real growth. Conversely, stocks could fall even with reasonable earnings growth if that growth comes mostly from high inflation.