Time to take a long-term look at stock markets

When questioned about the implications of the volatility witnessed in stocks, bonds, commodities, currencies and even property over the past two weeks, this column continues to rely on a quote from Benjamin Graham, the legendary US investor and mentor to Warren Buffett: “In the short run, markets are a voting machine but in the long run it is a weighing machine.”

By this, the author of the seminal book The Intelligent Investor meant that fear and greed and investment fads and fashions will dictate where securities prices go in the short term while corporate profits and cash flow will ultimately have the final say.

It is too early to tell how the British vote to ‘Leave’ the EU will affect UK plc’s earnings power (for better, for worse, or if at all) and it is only through careful study of macroeconomic data and company reports that a fuller picture will start to emerge.

But as the dust settles advisers and clients, helped by well-run funds, can already start to assess what is being priced into stocks – and whether markets are potentially too risk-averse (if valuations are too low) or too complacent (and valuations are too high).

Too much fear and stocks (or other assets) could represent bargains for the patient, risk-tolerant portfolio builder. Too much greed and more caution may be merited as downside protection may be inadequate, in the event of unexpected shocks (such as an economic downturn in the UK).

As Graham put it in the 1934 piece Security Analysis, co-written with David Dodd: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

It is valuation that can help to protect the downside, so this column this week will look at how US and UK stocks seem to be valued, relative to their history.

To save time-pressed advisers and clients the trouble of reading the rest, the conclusions are as follows:

For the USA:

  • US equities look expensive relative to their history on market-cap-to-GDP and the Case-Shiller CAPE metrics.
  • This suggests the markets are complacent, especially as corporate profits appear to be under pressure.
  • As such, America’s status as a haven market needs to be researched carefully, although a recovery in corporate profit momentum would help to justify prevailing valuations and provide some comfort.

For the UK:

  • UK equities also look expensive relative to their history on a market-cap-to-GDP basis.
  • This also suggests the markets are complacent, especially as corporate profits appear to be under pressure.
  • The UK stock market seems to be drawing support from its dividend yield. This easily exceeds the yield offered by cash or the 10-year Gilt and could be catching the eye of income-hungry advisers and clients, who must nevertheless ensure that their chosen fund managers in this area are thoroughly checking the reliability of those dividend payments. If they do prove to be safe, the FTSE All-Share (and FTSE 100) may attract further support. If dividends are cut, there could be trouble ahead.

America

At 2,089 America’s S&P 500 index is within a couple of percentage points of its all-time high, just north of 2,100. As such it is proving much more resilient than the FTSE 100, which at 6,500 trades some 10% below its May 2015 peak.

Throw in a stronger dollar, which at $1.29 to the pound stands at a 31-year high relative to the pound, and it is easy to see why some advisers and clients might head Stateside in the search for a Brexit bolt-hole.

Yet care is needed.

This chart shows how the US equity market (using the Wilshire 5000 index as a broad benchmark) trades on a high valuation, relative to its own history, using market-cap-to-GDP as a benchmark:

US stocks look expensive relative to their history on a market-cap-to-GDP basis

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Of equal concern, is the lofty cyclically-adjusted price/earnings ratio (CAPE), devised by Professor Robert Shiller. US stocks have only traded on loftier multiples twice in their history and the end-game made for ugly reading in 1929 and 2000:

US stocks look expensive relative to their history on a CAPE basis

Source: www.econ.yale.edu
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

These figures must be put in context for two reasons:

First, US corporate profits as a percentage of GDP stand at 11.7%, compared to a post-1950 average of 5.1%.

US firms are currently way more profitable than the historic average

Source: FRED, St. Louis Federal Reserve Database, Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Second, corporate America is a very different beast from 20 years ago, let alone 50. According to research from intellectual property investment bank Ocean Tomo and UBS, intangible assets, such as patents, trademarks and copyright, now represent 84% of the total US corporate market value, against just 32% in 1995 and 17% in 1975.

In other words, the US is a much more modern, productive, asset-light and less capital-hungry economy.

US firms are now more reliant on intellectual property than plant and equipment

Source: Ocean Tomo (2015), UBS

It is therefore possible to argue that US firms are bound to be more profitable than ever before and as such they should be more highly valued than ever before.

The potential fly in the ointment here is that US corporate profits are coming under pressure.

Dollar strength does not help, and nor does an economy that is still struggling for escape velocity, despite very low interest rates, burdened as it is by huge debts.

Calls for a $15-an-hour minimum wage are also putting on the squeeze.

This chart shows how corporate profits as a percentage of GDP peaked in Q3 2014, while earnings have fallen year-on-year for each of the past three quarters:

US corporate profitability is coming under pressure

Source: FRED, St. Louis Federal Reserve Database, Thomson Reuters Datastream

This could pose a danger to lofty US equity valuations, which to a degree rely on it being “different this time” when it comes to corporate profits. A sustained loss of momentum could put valuations at risk, pressuring share prices and headline indices, so the imminent Q2 reporting season (which begins with aluminium giant Alcoa on Monday 11 July) will be an important near-term litmus test.

UK

UK equities also look expensive relative to their history on a market-cap-to-GDP basis, although the current 110% ratio does come in below the 116% peak of Q3 2007 and the 131% all-time high of 2000.

The post-1988 average is 87%.

UK stocks look expensive relative to their history on a market-cap-to-GDP basis

Source: Thomson Reuters Datastream

The good news is British firms have never been more profitable, a situation which helps to justify that historically lofty valuation:

UK firms are currently way more profitable than the historic average

Source: ONS, Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

The bad news, also in a mirror image of the situation in the US, is that corporate earnings peaked as a percentage of GDP in Q3 2014, while profits growth has been basically zero for the last six quarters, ranging from -1% to +3% year-on-year.

A sluggish economy, reliance on debt-fuelled consumption and cost-pressures from the Living Wage are all factors to consider here.

UK corporate profitability is coming under pressure

Source: ONS, Thomson Reuters Datastream

Any further loss of momentum could hit sentiment and persuade the markets that valuations are indeed historically stretched, especially as weaker profits could hit dividends – and it is the dividend yield that seems to be providing support to the UK equity market right now.

A near 4% dividend yield on the FTSE All-Share may look tempting to some advisers and clients, especially relative to the record-low rates available on cash and the 0.785% 10-Year Gilt yield.

UK stocks appear to offer a substantial premium yield relative to Government bonds

Source: Thomson Reuters Datastream

That 290-basis-point (2.9%) yield premium may draw in income-hungry portfolio builders and provide support to stock valuations in the UK.

But if profits come under pressure, dividends may too. Dividend cover for the FTSE 100 is just 1.5x for 2016, based on aggregate analysts’ consensus forecasts for earnings and dividends, some way below the 2x ratio that provides real comfort.

UK dividend cover from earnings looks lower than ideal

Source: Digital Look, consensus analysts' forecasts

If the UK’s big caps hold their dividends, the markets may hold their nerve. If not, valuations could come under fresh pressure.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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