Many investors fear that equity market valuations have reached excessive levels. A recent BofA survey indicated that 46% of professional investors consider stocks overvalued; this is a record level, even higher than that observed in the late 90s, just before the internet bubble burst.
Despite the abundance of statistics measuring performance and prices, valuing the market and the stocks it trades is not an exact science. Two investors using the same information to evaluate a company and its market price could reach diametrically opposite conclusions, and indeed they do every time a stock is traded. We use various mathematical models, but even these hide subjective choices: in fact, it is enough to vary some inputs marginally, such as the discount rate, to reach macroscopically different values.
Today we could say that shares are traveling on challenging multiples compared to their recent history. The MSCI World index (world stocks) trades at an earnings multiple of around 17x, not far from its 10-year highs. If we extend the observation to a longer period, we are instead well below the long-term average (18x) and at levels well below the maximums recorded in the last century.
But a further dimension must be added: in fact, it cannot be considered a market in isolation from the others. Before reaching a conclusion on the stock market let's see what the alternatives could be. Years of expansionary monetary policies by central banks have caused yields on the bond market to be extremely compressed and real yields (adjusted for inflation) to be close to, or sometimes below, zero. Conversely, equities offer an average yield of 2,5% through dividends.
In other words, what premium does the market give us for taking the risk of holding shares? We calculate the difference between the profitability of a company (or an index) compared to its price and compare it with the yield on government bonds (a measure called the equity risk premium). To date, the eurozone equity market offers a premium of 7,5% over government bonds, a level that compares with the 6% average of the last 20 years. This is a confirmation of how, today, there is greater value in shares than in bonds.
We also introduce some considerations on the economic cycle. We are in a period of synchronized growth in the main economic areas and of normalizing inflation.
While it is true that we are experiencing a particularly long economic cycle that cannot last forever, it is equally true that taking profit too early could prove to be very costly. In December 1996, Alan Greenspan used the term "irrational exuberance" in a television interview with reference to stock market prices. He was probably right, but before the bubble burst another four years passed and the US index (S & P 500) doubled in value before collapsing.
The purpose of these considerations is not to further confuse ideas about market valuations, but valuations are not always the main driver of the market and prices can stay high, and get even higher, for very long periods. For there to be a turnaround requires an abrupt end to good economic data or a radical change in monetary policy. As of today, a recession, an inflation shock, a monetary policy error doesn't seem to be in the immediate vicinity.
° The author is the Chief Investment Officer of UBS WM Italy
