In the face of the deepest global recession since the 1930s and the unfolding health crisis, share markets have rebounded strongly. Since the low reached in March 2020, the United States share market is up more than 45% and the Australian share market has risen nearly 35%. The strength of these recent gains suggests caution is warranted with these markets now looking expensive relative to the earnings outlook.
In the US, the S&P 500 index is trading at a 12-month forward consensus price-earnings (PE) multiple of 21.9 times, well above the 10-year average of 15 times. The Australian share market is currently trading at 19.1 times, a level higher than the long-term average of 14.5 times. Lower interest rates may justify above average PE multiples, but high valuations also have the ability to reduce expected long-term returns. This reflects the notion that given any set of future cash flows, the higher the price you pay today, the lower the long-term rate of return you can expect on your investment.
Higher PE multiples can be partly explained by a fall in earnings per share, as company earnings have been impacted by the pandemic. In the US, the market consensus is for S&P 500 earnings to return 2019 levels by 2021 after a decline of around 35% for the 2020 calendar year. For the ASX 200, earnings are expected to decline by 20% this calendar year, and be 10% below 2019 levels by end-2021. These earnings estimates should be viewed with scepticism given many companies have yet to update the market since March and a significant level of market uncertainty still exists.
While there is a tendency to focus on short term earnings, valuations ultimately reflect cash flows over the long term. As a hypothetical example of how little the short-term matters, a 50% fall in earnings for two years, and then returning to levels that are permanently 5% lower than otherwise, implies a drop in value of less than 10% using a discounted cash flow model. On this basis, the 35% fall in share markets in February and March was an over-reaction, and helps to explain the market rebound once there was more certainty about the earnings impact.
It is worth noting that share markets (including most other asset classes) were already expensive heading into the crisis, driven up by ultra-low interest rates over recent years. Accordingly, we had been advising clients to plan for lower long-term future returns on the basis that the effect of lower interest rates had been to pull forward future returns to the present. To the extent that share markets have recovered to pre-crisis levels (e.g. the S&P 500 is within 5% of its all-time high), we are effectively back to where we started in this regard.
A major reason for the dramatic recovery in share markets has been the massive amount that governments are spending, including printing trillions of dollars, euros, yen and yuan to offset the economic shock brought on by the pandemic. This has created a lot of excess liquidity in the system which is boosting asset prices. Against this backdrop, just because markets are overvalued, it doesn’t mean they can’t keep rising for much longer. As an example of how stretched valuations can become, the former US Federal Reserve Chairman, Alan Greenspan, warned about “irrational exuberance” of share markets in 1996 - more than three years before the market peaked at the end of the dot-com bubble in 2000.
Following the strength of the recent rally, together with risks around a second wave of infections and US politics heading into the election in November 2020, we do not suggest increasing your overall exposure to growth assets in portfolios. However, we also would not suggest reducing exposure given that fiscal and monetary policy will continue to provide support for share markets. As we have been reminded during recent months, market timing is challenging. Staying invested, being prepared to look through short-term volatility and controlling risk through appropriate diversification remains the best approach to achieve long-term investment objectives.
If you would like to discuss your personal investment strategy, contact a BDO Private Wealth Adviser today.