In May 2013, I wrote this piece on valuation – Equity Markets: Valuation is in the Eye of the Beholder – which I think might be worth revisiting for anyone querying current valuations in equity markets and the outlook for expected returns. I continue to believe that valuation, like beauty, is highly subjective, and in the short term the tendency for the crowd to crave the same thing will be the driving force in markets. This is why markets are so unpredictable, particularly over short time horizons.
If we look at the valuation of the S&P 500 back then, the index of 500 large cap US companies traded on a forward 12-month price/earnings multiple (P/E ratio) of 14.4, above the 5-year average (12.9) and 10-year average (14.1). However, that gap has since widened. The current 12-month forward P/E ratio is now 16.7, above the 5-year average (13.9) and the 10-year average (14.1). Supported by the not so invisible hand of the US Federal Reserve and its central bank peers, the S&P 500 has risen circa 28%.
Of course, I didn’t know the S&P 500 was going to rise 28%, none of the bulls did for certain. All I, or anyone else, could infer from the situation was that the absolute valuation of the S&P 500 at that time was less important than the outlook for monetary policy. You can add extra layers of analysis, but this has been the predominant theme for years, and one that has continued to drive investor behaviour and hence the performance of risk assets. Central banks have helped many people in the financial markets look smart.
So where do we stand now? The S&P 500 is trading at a higher valuation and the Fed is much closer to embarking on a journey with no map to guide the way. It would seem naive to think that the Fed can normalise monetary policy without hurting the economy and company profits. At the very least, we are surely guaranteed the odd misstep. (Of course, it might all be a moot point if the recovery turns out to be weaker than expected once again, prompting a further delay in rate hikes. Then the bigger question would be how long before there is a loss of faith in these institutions?)
Finally, I recently read Boris Johnson’s book on Winston Churchill – The Churchill Factor – and there there was a quote I took from it that I think pertains aptly to the world of financial markets, and which should hopefully provoke some thought on market predictions and timing markets in the short term.
“In 1902 Churchill observed that a politician needs ‘the ability to foretell what is going to happen tomorrow, next week, next month, and next year. And to have the ability to explain afterward why it didn’t happen’.”
Why do politicians have to be able to do this? In my view, it is the same reason why some investors crave short term market predictions, because people have an overriding desire for certainty in a highly uncertain world. Analysts with unrivalled access to company management are unable to predict earnings accurately one quarter ahead, so I prefer to save the short term predictions for the gambling world, and focus instead on the broader themes driving financial markets. That way, I’ve less explaining to do!