A tenuous title to lead an article about equity indices hitting peak levels, but any chance to promote the best UK television series in history (Line of Duty a very close second and, no, I haven’t watched Vigil yet) seems like a free hit. Yes, big tech stocks have played a blinder (I’ll stop) and lifted the Nasdaq to all-time highs. The S&P 500 has enjoyed similar headlines earlier in this quarter, prompting the immediate headlines that either a) markets will continue their rally ad infinitum, or b) we’re all doomed. Suffice to say neither is likely.
Looking under the bonnet for a moment, the headline writers are missing a subtle shift and that is one regarding valuations. One of the features of the corporate recovery since the lows last March, is the strength and the speed of the earnings recovery. There has been record earnings growth in the US in the last few quarters and if analyst expectations for the rest of the year are met, then earnings growth from those companies in the S&P 500 are set to reach 42% for 2021 according to Factset, and 2022 calendar year earnings growth is being projected at 9.5%. Corporate health is strong in many other areas too. Those companies that are considered higher quality, investment grade firms are holding high levels of cash, improving their balance sheets and leverage (their borrowing) levels. With a decade or so of low interest rates and now almost two years of ultra- low interest rates, companies with access to the bond markets have been actively refinancing their debts to replace existing debts with those enjoying even lower interest rates and lower servicing costs. This process has trickled down into the lower quality, high yield market as they became open to new issuance too. Corporate profits are continuing to recover impressively as well, already surpassing previous highs, with US company profits breaking record highs in Q2 this year.
In Europe, the earnings recovery is still positive, but less pronounced as continued lockdowns and a slow pace of vaccine rollout hampered the early corporate recovery. Notwithstanding, overall levels of debt have fallen in European companies too and with the vaccine programme coverage in Europe now outpacing that of the United States, a delayed boost to those corporate earnings can be anticipated as European consumers come back to the fore.
Steadily but surely the improving earnings outlook is gently taking down overall market valuations. At the beginning of the year, the S&P 500 traded on a forward price earnings valuation of around 23x. By the end of Q2 this had fallen to 21.4x and, most recently, this has dropped to 20.9x. Still this should be considered expensive versus its history, but investors remain prepared to pay up for accessing the more dynamic corporate environment and its continued strength and healthy profits. Elsewhere valuations look less expensive, developed European and emerging markets are trading just above average and Japan looks relatively attractive. Similarly, in the UK, the FTSE 100 started the year at around 15x earnings and is now sitting just above 12x, which sits under its median average and has a yield around 3%.
So, in a world where the headline writers solely focus on index levels hitting historic highs for equity markets, spare a thought for the under-reported earnings picture, which is helping, slowly but surely, to improve the valuation outlook.
So there follows a question, with stock markets having risen so far from their March lows and hitting recent all-time highs in the US, does this make us closer to a market correction? Well, whatever event is being measured, being one day further away from the date of it last occurring without it occurring again makes us by definition to be closer to the next time it happens. The question should really be, are we close to a correction in equity markets? To that end, what would typically trigger a big equity sell off? The early noughties/tech sell off was triggered by a collapse as equity markets fell under the weight of their own valuation; the financial crisis was triggered by loose lending practices and over-extended banks. In the main, we are not in either place right now; valuations are in an acceptable band and corporate health including that of the banks, remains good. Notwithstanding a black swan event, what continues to be the most likely setback for now is a pandemic related event that would trigger some mass return to lockdowns, but with each vaccine that gets distributed, we move one jab further away from that becoming a reality.
We are not market timers, the portfolios we manage are long-term and strategic by nature and we let valuations be our primary guide to the amount we allocate to the various asset classes. Starting valuations matter. At this point, we continue to retain a balance of equity exposure across sectors and geographies and have no immediate plans to change the current balance. In fixed income, where valuations are looking historically expensive, both in terms of the headline low yields available but also in terms of credit spreads, we continue to believe sheltering in short-dated bonds and using flexible strategic bond funds is a sensible way forward.
For now, markets remain in an inelegant muddle through phase, economies are functioning but struggling to release themselves from the shackles of both COVID and the disruptions it has caused to supply chains and consumer mentality. We remain positive for the longer-term but wary that risks remain on the horizon and aware that policy error has become heightened. At this point, we do not believe investors will be best served siding too heavily with the bulls or the bears and remembering that the short-term can be very noisy with explanations handily coming post-event. Keeping an element of balance in portfolios and not getting carried into the momentum or the doom-mongering is a strategy that has served us well since we started managing discretionary portfolios. It is unlikely to send us too far wrong in the future too.