Valuation is in the eye of the beholder

• Equities may appear expensive relative to history based on forward P/E metrics but that's because earnings have been revised downwards substantially. But earnings at inflection points are never revised proactively, suggesting that they do not paint an accurate forward looking picture
  
  
• Higher equity prices are justified by much lower bond yields today. The equity risk premium for holding equities today is higher than what was offered back at the beginning of the year
  
  
• Poor sentiment and the reopening of the global economy suggest that expectations are easy to beat, which may provide further fuel to the upside for equities
  
  
• We think global equity funds with a focus on higher dividends could be an area investors can take advantage of in the current reflationary market environment

Global equity markets have been on a tear lately. Its meteoric rise from March lows have attracted many to start calling for a downward turn in equity markets. Valuation metrics of global small, mid and large caps (as represented by the MSCI All Country World indices) are all trading at levels that are much higher than their respective long term averages.

Table 1: In absolute terms, valuations based on 2021 earnings appear pricey

Source: Bloomberg Finance L.P., iFAST compilations

Data as of 31 May 2020

But equity valuations always appear stretched during periods of crises. Simply look back to the GFC, Eurozone crisis, China deleveraging crisis, or even the current debacle we are in, the 12 month forward Price to Earnings (P/E) or Price to Book (P/B) valuation metrics is almost always considered too high. These indicators have never been a good indicator during inflection points. One reason why is because earnings are often never proactively revised ahead of price movements.

Chart 1: Price bottoms before earnings estimates do

We often base our views of whether something is cheap or expensive relative to its historical prices. In absolute terms, global equities are now trading at levels where they nearly a year ago, despite projected earnings falling close to half from what they were. Stating that equities are expensive and should be avoided would be an easy conclusion.

However, looking at P/E alone (especially in an abnormal market environment) may be insufficient. Assets tend to be priced in reference to other competing asset classes. Equities and bonds are no different. Knowing how equities are priced relative to bonds essentially gives investors a better idea of how to allocate between the two asset classes.

Lower bond yields mean that equities have to be priced higher

In this case, the excess earnings yield (earnings yield less 10-year US treasury yield) that equities provide disagrees with what the P/E metric is suggesting. This is because the price of US treasury bonds in relative terms have appreciated significantly as central banks pledged to keep yields and rates low.

Excess earnings yield is saying that equities are neither cheap nor expensive at these levels as they trade near their 10-year historical average. This is the rough level of which market participants have generally agree upon across time, how much equity risk premium is required to hold equities. Even before the pandemic happened, there have been instances when it was more expensive to invest in equities relative to bonds (excess yields below long term average).

Chart 2, 3 & 4: Excess yields earnings of global small, mid and large caps using 2021 estimates

What is likely to drive this recovery in earnings?

Given the large gap between negative EPS revisions between 2020 and 2021/2022 (see Chart 1), consensus estimates currently expect a strong bounce for the global economy into the next year. So what is driving this optimism? Largely, high expectations stemming from record levels of fiscal and monetary stimulus injected by central banks and governments, we believe, are driving prospects of a strong recovery in earnings and economic activity.

But firstly, market participants will need to see some semblance that the worst is over. Ultimately, how quickly the global economy will recover depends on how quickly businesses can reopen, and how much money businesses and people have to spend and generate economic activity.

We know this to be true to some extent because we see some evidence of market bottoms coinciding near or at the peaks of unemployment claims made by individuals. Lower unemployment claims at a time when the global economy is reopening is indicative, and supportive, of an economic recovery in the months ahead as individuals return back to work.

We use the US as an example given its considerable size and influence in the global economy. Across decades, we find that major market bottoms are found around the peak of unemployment claims after a crisis, which also often coincides with a beginning of most market recoveries. The equity market rebound, from this perspective, is not irrational as some market observers might believe.

Chart 5: From 1971 – 2015, data suggests markets tend to bottom right around when unemployment claims peak, an indication that the worst is probably over

Chart 6: Jobless claims peaked in end April – just right before the market bottomed

Should positive economic surprises start to come in in the quarters ahead, it supports the thesis for further price appreciation for global equities as consensus reevaluate their beaten down earnings estimates.

Chart 7: Low expectations right now may serve as fuel for potential surprise to the upside

Participating in the cyclical recovery

The gradual steepening of the yield curve on the longer end continues to favour the narrative of a recovery in growth prospects. In any recovery, we believe high dividend paying funds could become more attractive to investors as risk appetite rises. The highest dividend paying global equity funds investors may consider are listed down on the table below. With dividend paying funds, we recommend investors to reinvest any payout as long-term compounding of dividends is key in contributing to your portfolio’s total return.

Table 2: High dividend global equity funds on the platform

^Based on latest indicative yield on the platform

On the other hand, small and mid-caps currently have excess yields higher than their long term averages – so smaller cap equities will be good places to bet in anticipation of reflation. While we do not offer a global small cap product, investors may build their own via individual products that have a focus on each region. To look at the list of products available, simply head on to Fund Selector, pick Equity, Small to Medium Companies as appropriate filters, and hit Generate Funds Table. Besides, our views on US small caps remain the same. We believe they are potentially on their way to outperform over the near term. Alternatively, investors may consider looking at funds such as Blackrock World Financials A2 SGD-H and Fidelity Global Financial Services A-ACC-SGD as more concentrated bets.

A time to be cautiously optimistic

Could this be the quickest global recession ever? Given the range of unknowns, it could be too quick to conclude that the worst is over, even as odds suggest that it might be the case. There are still many factors that could derail this market recovery. We may have averted a liquidity crisis in the first of the year, but a potential corporate solvency crisis could be brewing in the background as we begin to see bankruptcies occurring in some parts of world. No one can say for sure.

However, our thinking is that governments and central banks worldwide have shown willingness to shove aside fiscal and monetary prudence until they begin to see results of a sustained recovery in their respective economies. Furthermore, politically there is a lot riding on 2020. The world’s biggest economy has its presidential elections coming up later in November, and there will be a lot of pressure to keep the liquidity spigots running at least until after the elections.

Also, whatever happened in markets during February and March was a health crisis. It would be logical to expect it to be resolved with a medical solution. There’s a lot of money, research effort and political capital invested to finding a vaccine across the world. This gives investors hope that the world will soon find a solution. By then, equity markets could very well be on its way up before you even know it. Timing the market would be near impossible. In this news-driven market environment, we maintain our belief that staying invested via regular savings plan is the best way for retail investors to mitigate risk and participate in any potential upside ahead.