Is it time to invest in equities?

Key points:

• Global equities have only been more expensive than current valuations for 10% of the time in the last 33 years based on price to earnings (P/E) ratios
• But P/E ratios may be poor valuation metrics for asset allocators at a time of very low bond yields
• The equity risk premium is likely to be a better valuation tool for investors and suggests that equities can generate positive annualised returns over the next five years
• As the “reflation” trade attracts more converts, it may be time to increase the cyclicality of equity portfolios
• A strong preference for “quality” companies and exposure to industrials appeals.

With many equity markets setting fresh highs this year and seemingly priced for economic recovery, strong earnings growth and continued fiscal and monetary support, many investors be hesitant to invest. While traditional valuation metrics might appear unappealing, their relevance looks limited in the current, low interest rate, environment.

Just how stretched are valuations?

Equities have rarely appeared richer on a price-to-forward earnings ratio (P/E) basis, the most widely used valuation metric. Indeed, the MSCI All Country index trades at around 20 times consensus earnings over the next twelve months.

Monthly data from 1988 suggests that global equities have only been more expensive for 10% of the time in the last 33 years. No wonder investors may fear investing at current market valuations and hold off doing so until the entry point offers better value. But can P/E ratios be trusted?

Better understanding of P/E ratios

While P/E ratios may seem rich, arguably they offer little insight. Three flaws stick out when relying solely on the ratio to inform investment decisions.

First, as an aggregate measure, index-level P/Es are influenced by how the market being represented is composed. Changes in consumer attitudes and regulations can affect valuations and are just two reasons why comparing the ratio across decades, as index constituents change, may have limited use. For instance, the emergence of many large, higher-growth technology companies this century seems to be distorting historical comparisons.

Another issue with P/E ratios is that they ignore elements that can be crucial to assessing the attractiveness of any investment, such as long-term growth prospects and the cost of capital.

Finally, and maybe most importantly, P/E ratios aren’t usually a good predictor of returns. Valuations are generally mean-reverting and arguably are more likely to contract than to expand from current levels. Yet, this does not necessarily mean that equities are headed for a correction. Indeed, earnings tend to be a much more important driver of returns. As long as earnings can outgrow contracting multiples, then positive returns should follow.

Widening the scope

Because P/E ratios aren’t reliable valuation tools, especially in a period of extremely low interest rates, alternative metrics may be needed.

When evaluating specific stocks, return on invested capital (ROIC) is often more preferable, as it successfully overcomes the effect of capital structure on companies’ performance. In addition, when measured against the weighted average cost of capital (WACC) – which de facto includes the impact of changes in interest rates – ROIC allows investors to assess the business’ ability to generate value for shareholders. 

The ERP and why equities appeal

For broader indices, and because ROIC may be less relevant for certain sectors, the equity risk premium (ERP), or the difference between expected earnings yield and the yield on risk-free instruments such as Treasuries, may be preferable. The ERP is likely to be the most relevant when choosing which asset classes to invest in.

Following the Democrat victories at the US presidential election and subsequent Senate runoffs in Georgia, significantly higher fiscal stimulus looks likely. As a result, the yield on 10-year Treasuries has risen steadily, recently breaking above 1%.

The increased Treasuries yield has pushed the ERP below 350 basis points, its lowest level since mid-2018. However, based on this metric, equities remain much more attractive than risk-free bonds and much less expensive than they were in the early 2000s.

Keep an eye on 10-year yields

The ERP is in the middle of its historical range in percentile terms. This suggests that equities can still generate positive annualised returns over the next five years.

By itself, a rising 10-year bond yield isn’t necessarily bad for equities. As long as higher rates are the result of more growth, both in economic activity and companies’ profits, equities may still perform well.

Timing is important too. If the 10-year bond yield rises too soon, and too fast ahead of the improvement in earnings, then the ERP would likely contract to dangerous levels.

Time to be brave

In this context, being invested seems the best course of action. As the idea of a “reflation” trade is gaining traction among investors, slightly hiking the cyclicality of equity portfolios seems to make sense. A strong preference for “quality” companies (implying an attractive ROIC) over others appeals. On a sector view, this might translate to more exposure to industrials, moving away from staples and other bond proxies.

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

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