Debunking the bears part 2 – Valuations are stretched

Miles Staude

Where the argument that current share market valuations are too high generally breaks down is that it is based on comparing current P/E ratios to very long-run historical averages. In this video and edited transcript below, Emma Davidson poses the question of whether valuations are too high to Miles Staude of the Global Value Fund.

When interest rates are high, P/E’s are low, as they were in the 70’s, and when interest rates are low, as they are today, P/E’s are high. That statement is a truism, pointing it out isn’t an argument that equities are overvalued.

Making a useful comparison

Comparing P/E ratios today, against the P/E ratios of, say, the 1970’s, with inflation and interest rates in the region of 15%, offers us no real insights into what is going on in the market today.

When interest rates are high, P/E’s are low, as they were in the 70’s, and when interest rates are low, as they are today, P/E’s are high. That statement is a truism, pointing it out isn’t an argument that equities are overvalued.

More importantly though, share markets price in future earnings expectations, not historical earnings. The global economy is currently in its best shape since before the financial crisis and that is flowing through into company’s earnings. The move we have seen in global share markets over the past 12 months has just followed increasing forward earnings estimates. Valuations, despite a 20% plus market rally are essentially unchanged, the forward P/E ratio for global shares markets is currently about 16x, which give or take is where it has been for several years now.

Shares still offer value

Relative to other asset classes, shares still look like good value, in fact you could even call them cheap. I know that might sound like a stretch to some people, but the earnings yield that shares offer today is far higher than the returns on offer from other major asset classes, like high-yield or corporate bonds, where yields, especially after accounting for inflation, have basically disappeared. Shares are riskier investments than bonds, and it is normal that they should offer a greater yield, but the difference between the two asset classes is now far greater than what it has been in the past. Shares are far better value than most other investment alternatives today.


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sachin saraf

Fact shows that the recent rally is all but PE expansion so any disappointment and the impending correction (crash) will pull the rug out

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Hardin Smith

So with the US raising interest rates and reducing QE along with Japan a spike in interest rates may reduce the markets PE?

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Joost Daalder

Yields for corporate bonds have not disappeared. On the contrary, they are actually quite high. At FIIG's a well selected portfolio will yield about 7%.

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Emma Davidson

Thanks for commenting Sachin Saraf, appreciate the time. I agree with you that if future earnings estimates disappoint, this would negatively impact that market. It would however seem that there would be more downside disappointed risk for markets if this recent rally had been predicated on both expanding P/E ratios and rising earnings forecast, as opposed to just the latter.

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Emma Davidson

Absolutely agreed Hardin Smith and thank you for the comment. The counter argument I believe is that there is no good reason to think that steep interest rate rises are going to happen any time soon. Yes, interest rates are going to slowly start going up but there is no reason to think they are going to go anywhere near where they used to be for a long while. The forward interest rate curve in the US goes out as far as 30 years and it is currently pricing yields in 2047 at 2.80%, which is almost half the long-term average (50 year average: 5.30%). As far as QE is concerned, yes, the US has said it is going to start reducing QE but in aggregate, central bank balance sheets are going to continue to expand as Europe and Japan embark on further QE.

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Emma Davidson

Thank you for your comment Joost Daalder. In this post, I believe Miles was referring to international investing (as opposed to onshore Australia) where yields in the major global currencies like USD, EURO, YEN have all but disappeared when accounting for inflation. Here is an interesting article entitled “Over $9tn of bonds trade with negative yields” from the FT in London https://www.ft.com/content/86e1e87e-81ed-11e7-a4ce-15b2513cb3ff. I believe you are referring to Australia where, yes, interest rates are higher which push yields higher. It is probably worth highlighting however that to get an average bond yield of 7% in Australia, it seems likely that a meaningful part of your portfolio will be invested into sub-investment grade debt, which offers more yield, but comes with its own unique risk profile.

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