05 Feb 2021
February 2021| Paul Niven, Managing Director, Portfolio Manager and Head of Portfolio Management, Multi Asset Solution
After the brutal sell-off in the first quarter of 2020, equity markets embarked on a rally which was to confound even the most optimistic expectations. Despite lockdowns leading to a collapse in economic output and a sharp downturn in market-wide company profits, equity markets have reached new record highs, pushing valuations to historically high levels. But, in a world where interest rates are at all-time lows, equities still represent relative value. Is this meteoric rise in equities a signal to investors that a sustained market downturn is imminent? We think not. Paul Niven, Head of Portfolio Management, Multi-Asset Solutions, explains why he is still positive on equities.
At 33 times estimated 2020 earnings, the current price-to-earnings (PE) ratio of the S&P 500 index, is at a record high. While headline multiples are inflated by depressed earnings, the PE ratio is higher than it was at the start of 2000, just before the dotcom bubble burst, when the PE ratio of the index was 31. There is a strong case that, with high multiples, future returns will be lower, but one needs to be cautious about a fixation on historic comparisons and drawing strong conclusions over near-term return prospects.
Yes, the current PE multiple is higher than before the dotcom bubble burst, but trailing market earnings are depressed and the financial backdrop now is very different. The 12-month forward price-to-earnings PE ratio of the S&P 500 index is 23, reflecting the strong expected growth in consensus earnings per share (EPS) this year. It’s been this recovery in forward earnings that has taken equity markets to new highs. The correlation of share prices to earnings has surged, while the correlation of forward PE valuations has faded away.
We have seen unprecedented stimulus from central banks and governments through monetary and fiscal means to combat the impact of Covid-19 lockdowns and this is supportive for risk assets. In addition, yields on government bonds are at historic lows and are likely to stay there for the foreseeable future. Some market commentators are making noises about the potential for a rise in inflation. This is the key risk for markets and, while there are some indicators that show price rises over recent months, there are also substantial arguments for why a sustained increase in inflation is unlikely – but we will leave that discussion for another time!
The bottom line is that, with the huge burden of debt that governments have been forced to take on to save their economies from severe recessions, the cost of repaying that debt will be held as low as possible; in other words bond yields are unlikely to rise anytime soon. And within this context, equities look cheap regardless of their high levels of valuations.
No! Pockets of excess do currently exist in equity markets, but these tend to be concentrated in a few headline-grabbing names. There will always be share prices that are supported by speculation, rather than the company’s earnings capacity. And in these times of Twitter and instant access to news, this disparity can be much bigger, and occur more rapidly, than we have witnessed before. This is why we believe that an active approach to multi-asset investing means that clients can still reap the benefits of equity markets while avoiding those stocks whose valuations are unduly stretched.
To find out more how BMO Global Asset Management’s Multi-Asset team can actively help your clients avoid the valuation trap, please contact the BMO sales support team.
Risk Disclaimer
Views and opinions expressed by individual authors do not necessarily represent those of BMO Global Asset Management.
The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.