Much has been said recently about the need to de-risk portfolios. From Howard Marks (Oaktree) to Ray Dalio (Bridgewater Associates), there are many who believe now is the time. There are clearly geopolitical risks aplenty. But what about asset values? Let's touch on equity market valuations.
Global Price to Earnings ratios (PE) are above long run averages – that’s clear from the chart below showing global trailing PE’s now sit above 20 times earnings.
Chart 1: Global trailing PE
Source: Citi Research
This does not look like a chart of an asset class in bubble territory. Certainly above the median, but not necessarily anything to talk about. However, it is important to reflect on the impressive earnings growth that has contributed to this PE not being higher.
This has been driven to some extent by the huge cost cutting and buyback activity of recent years. There could be some risk in this PE multiple – capital requirements can’t be ignored forever. Companies must eventually re-invest, for maintenance and for growth.
And, of course, there is always the risk that top-line revenue or earnings also start to fall. While not forecast, the rate of change in earnings growth is slowing. Reporting season in Australia has been fair to average. Overall earnings have been downgraded slightly with positives coming from resources and overall a negative from the defensive sectors.
What about interest rates? Mathematically, low rates do provide a valuation tailwind on a Discounted Cash Flow (DCF) basis. But bond rates are at their lows and central banks would like to normalise their balance sheets. One would suggest risk is to the upside for yields and therefore to the downside for DCF valuations.
A second, well-followed, measure of market valuation, the Cyclical Adjusted PE (CAPE) ratio looks at 10 year inflation-adjusted historical earnings.
Chart 2: CAPE ratio
Source: Citi Research
Using average earnings over the last decade, the CAPE ratio helps to smooth out the impact of business cycles and other events and gives a clearer picture of a company's sustainable earning power.
It doesn’t look especially rich by tech bubble standards. However, in the tech bubble, we had many companies trading on high multiples with little or no earnings.
If we ignore that and look at the chart from 2003 below, we can see we are pretty much back at GFC levels for US equities. Closer to home, Australia is 1st standard deviation expensive.
Chart 3: ASX200 PE multiple
Source: Morgan Stanley
The August reporting season in Australia has been fair to average. Overall earnings have been downgraded slightly with positives coming from resources and overall a negative from the defensive sectors.
So overall whilst these charts might look a little rich, it’s hard to argue they are telling you to sell.
The geopolitical outlook though at present might.
Disclaimer: Please note that these are the views of the writer and not necessarily the view of Perennial.
Dan is a Portfolio Manager. He joined Perennial Value in August 2012 after 15 years at UBS Investment Bank where he held the position of Managing Director - Head UBS Fundamental Investment Group. In this role, Dan managed a seven person team...
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