Since equities are fairly valued, investors can expect a normal return of about 6% each year from dividends and growth. The rally of the past few months should slow noticeably and the risk of a correction will gradually increase from a valuation perspective.
The autumn of heated activity expected by us has so far turned out to be extremely mild. The first potential stumbling blocks for the equity markets have turned into positive catalysts. The European Central Bank (ECB) has delivered on its promise and at the beginning of September; it released details of a bond purchase programme to support peripheral bonds. One week later, the US Federal Reserve Bank (Fed) surpassed investors’ expectations and delighted the financial markets with a monetary policy double strike. That said, only time will tell whether this act of liberation has worked and although the public debt burden has not decreased in size, many investors have taken heart. The burning question on the equity markets is no longer “How high is the risk of a setback?” but “How big is upside potential?”
“After the rally in global markets, equity valuations are once again at the upper end of the historical post-crisis range. Since we see little chance of cyclical upswing and do not expect a massive re-allocation from bonds into equities in the short term, the upside potential for equity markets is limited and the risk of a correction is rising gradually,” Philipp Baertschi, Chief Strategist at Bank Sarasin, said.
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The ECB has fulfilled the most important condition from the financial markets’ standpoint by declaring its willingness to buy unlimited short-dated peripheral government bonds in the secondary market, and investors’ fear that the European Union (EU) rescue plan might be too small subsequently evaporated. The ECB has brought out the biggest weapon in its arsenal. Although it has not yet loaded this bazooka because countries first have to ask the EU for help, it is scaring off any would-be attackers. This is evident from the performance of credit default swaps in the peripheral bond market (see first chart pictured on the left). After the ECB’s pledge, taking a punt on a default on Spanish or Italian debt is no longer worthwhile. Although European banking stocks have also staged a strong recovery, they have risen considerably less sharply than credit default swaps. This is because while banks’ balance sheets profit from lower interest rates, their profits suffer under the Euroland recession. Since earnings expectations for the entire Euroland market have deteriorated further in recent weeks, the equity rally is solely fuelled by the decline in the risk premium associated with a euro collapse.
The Fed has also surprised markets positively. First, the Fed has extended the time horizon for low interest rates until mid-2015 and, second, it has announced a new open-ended bond-buying programme (QE3). Investors have reacted strongly to the news and hope the effect will be similar to QE1 or QE2. If we look at the loose correlation between the Fed balance sheet and the S&P 500 (shown in the last chart pictured on the left), it appears that equities have scope to climb. With purchases of about USD 600 billion planned for the next 12 months, the S&P Index could easy reach a new record level above 1,600 points.
Following the latest rally, the stock market has discounted a lot of good news. In contrast to its previous quantitative easing programmes, the Fed appears to be taking preventative measures. The latest economic data were more mixed than poor, and even inflation expectations indicate just a low risk of deflation. Unlike QE1 or QE2, the Fed’s decision has not come at a time when the markets are at low ebb, but has provided extra oil to grease the wheels of the existing rally.
The actions taken by central banks have led to a sharp decline in risk aversion among investors. Investors have wound up many of their hedges in recent weeks and hedging costs have dropped to their lowest level since 2007. This has also led to a revaluation of the stock markets. As equity prices have jumped while earnings estimates have mostly fallen, the markets’ price/earnings (P/E) ratio has now reached the upper end of the historical post-crisis range (see first chart pictured on the left). With a P/E ratio of almost 13, the US market is no longer inexpensive. The same is true of the European market, where the dividend yield has dropped well below the 5-year average.
In our valuation model, which takes different factors into account, the valuation is still relatively inexpensive thanks to the ultra-low real yields. However, the recent past shows that values below 0.5 were not very good entry points for equities. The exception was 2009, when corporate earnings hit rock bottom. However, corporate earnings are currently at record levels, and even profit margins are very high historically. There is a risk that earnings could spring negative – not positive – surprises on weak growth. We think that current consensus earnings estimates for 2013 are at least 10% too high. This means that the US equity market valuation based on future earnings is even expensive. The European equity market with a P/E of 10 xs still has a little catch-up potential, but the continuing recession is likely to squeeze earnings further. In the absence of a new cyclical upswing, the equity markets have only limited potential.
It will take a major structural reallocation of bonds or money market assets in favour of equities to overcome the prevailing valuation ranges of the post-crisis era. The following chart shows that this would be a profitable trade based on medium-term return prospects.