There is a relationship between equity market valuations and prospective returns. History suggests that today’s equity market valuations are consistent with positive expected returns over the medium term. Having a bearish view right now is simply arguing that there might be better entry points, not that you should never invest in equities at all. The best returns typically come from the sectors and markets that can deliver the best long-term earnings performance. The mood music isn’t great now given the macroeconomic risks but if an investment strategy takes a five-year view, then it is potentially not all gloom and doom.
What is a bear?
I re-read my note from last week and surprised myself that it came across as quite bullish on equities. History tells us that returns from equities are positive over time. Not all companies survive but investment exposure to a broad basket of listed company shares does almost always generate positive returns, contingent on an appropriate time horizon and (sometimes) the entry point – although not guaranteed of course. You can be bearish on individual companies – ones that have bad management or are in a structurally declining business sector – but structural bearishness on equities as an asset class is generally not a sustainable view to hold. The average garden-variety bearishness is typically just a call for lower entry points. It is important to distinguish between short-term trading calls and long-term investment exposure.
Markets are up significantly since their lows in October. Not only that but there has been a huge change in sector performance. In the period between the end of 2021 and the end of October 2022, the S&P 500 Energy sector delivered a total return of 67%. Since then, the total return has been -1.4%. By contrast, Information Technology delivered -26% and +10.8% in the same periods. Over the last three months, the leading sectors in terms of price performance have been Technology, Consumer Discretionary and Telecommunication Services. Value has still outperformed Growth by a small margin this year but by much less than the 20% or so seen in January to October last year.
Buy and hold
Historically, buying the S&P 500 with a 12-month forward price-to-earnings ratio (PE) at current or lower levels has delivered a positive five-year total return more than 90% of the time, with an average annualised return generally in the 10% to 20% range. By contrast, buying the market at a PE above today’s level has delivered positive returns only 60% of the time with an average annualised return of just 5%. Waiting in case the market drops 20% again should boost returns over time but it doesn’t mean getting into the market today is a terrible risk-return proposition. Yes, there is volatility, and yes, the macro outlook is uncertain. But time horizon counts. The lower PE ratios are, the better medium-term outlook for returns in the same way that higher bond yields deliver more attractive fixed income returns over time.
Admittedly, it’s hard to disassociate from the industry focus on the short term. Looking at long-term returns does, however, give a different perspective. Growth has been out of favour but historically, the strongest equity returns have accrued to those sectors (and companies) that have generated the highest level of long-term earnings growth. In the US, these sectors have been Technology, Healthcare, and Consumer Discretionary. My colleagues that help manage our quantitative equity strategies have pointed out that the current rally has been led by low-quality, high-beta stocks. This, traditionally, does not persist because they become too expensive, and eventually market leadership is taken over by Quality and Growth stocks again.
Non-US markets are attractive
Outside the US the valuation versus long-term performance is even more convincing. Japan had ridiculously high valuations in the 1990s which resulted in a decade and a half of five-year returns being either negative or, when they were positive, were not so for very long. Since the global financial crisis, the PE on the Japanese market has averaged 14.7 times (compared to 33.6 times in the two decades before). Returns have generally been positive over five-year holding periods since then. The 12-month forward PE is around 13 times. The analysis also works for Europe’s equity markets. In short, with a long enough time horizon, I believe investing at current market levels should potentially deliver handsome total returns over the next five years.
There are no crystal balls. If we assume that, in most cases (Japan in the 1990s being the exception), developed equity market returns are positive over the medium to long term, then being bearish is a short-term view. It also relies on the perception that market timing is an investment strategy with a high information ratio. It is not easy to pick highs and lows. For what it is worth, the short-term outlook is quite positive. Headline inflation is set to fall quickly during the first half of 2023; central banks are close to their final hikes of the cycle; growth is turning out not to be as bad as thought during the worst of the energy crisis last year; and market stresses are generally absent. Interest rate and credit spread volatility has continued to decline and this is a positive sign for risky assets.
But growth concerns remain
Long-term equity returns need growth in earnings. Earnings growth needs economic expansion. Avoiding a deep recession is key to markets being able to sustain their current positive momentum. What we don’t know is whether growth can continue with US interest rates staying at close to 5% and European interest rates at close to 3.5% for a sustained period (as central banks are arguing they should). The risk is that as nominal GDP growth slows with lower inflation, companies may have less pricing power and the cost of debt service might become more of a problem, ultimately impacting on earnings. Given the huge amount of corporate borrowing done in the bond market this year, that does not appear to be an issue now. Yet overall credit growth is slowing, and bank lending standards have tightened. Two observations that do point to downside risks – real M2 (US) money supply growth has been deeply negative over the last year and the US Treasury yield curve (10-year minus two-year yields) is more inverted than at any other time since 1980.
So bullish, but…
Let’s recap. Long-term equity returns should be positive given today’s valuations. The US market is far from cheap, but it is far less expensive than it was. Outside of the US, markets are much more attractively valued. Fundamentally, there is further potential weakness in earnings as the economy adjusts to higher interest rates over the course of this year. The risk scenario is that core inflation remains stubborn and interest rates go a lot higher than currently expected. The bond market is forecasting recession (rates cuts priced for 2024, inverted yield curve) and equity analysts are forecasting a rebound in earnings growth next year. The truth is no-one knows but the resilience of labour markets and the prospect of some huge structural drivers of investment spending in the years ahead suggest it is not all gloom and doom. The green transition, supply chain realignments, artificial intelligence and the metaverse are just some of the themes that will drive corporate spending over the next decade, providing multiple sources of growth in earnings for the stock market.
Yen to strengthen further
At the time of writing there was some excitement over the proposal for a new Bank of Japan governor. For those looking for a change in monetary policy, a change of leadership at the central bank is a clear step towards moving away from zero rates and yield curve control. The yen responded by strengthening although Japanese Government Bond yields remain anchored at 0.5%. Consensus forecasts have Japanese GDP growth relatively flat this year with core inflation slowing to between 3% and 4% after averaging 5% last year. That does not suggest a huge move is required in the monetary stance – but there is likely to be something given what has happened to rates in other major economies. It’s a fair bet that the yen strengthens further but it has already moved from 150 to 130 against the US dollar since last October. Against a medium-term horizon, the yen is weak and the big move higher in the dollar-yen exchange rate coincided with the beginning of the Federal Reserve’s tightening cycle. If the Fed is nearly done and the Bank of Japan is going to move away from a policy that has been in place for a long time, then a target of 120 would seem reasonable over the course of this year.
The Look of Love
Sad to hear of the passing of Burt Bacharach. His songs have stood the test of time and - for someone of my age – trigger plenty of associated memories. From the iconic scene in Butch Cassidy and the Sundance Kid -Raindrops Keep Fallin’ on My Head, to Dionne Warwick’s soulful delivery of Walk on By, his catalogue is pure class. Let’s take a moment to reflect on the sentiment of one of his best songs and remember one of the greatest songwriters of our time – What the World Needs Now is Love.
(Performance data source: Refinitiv Datastream).
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