Favourable tailwinds for now, but don’t ignore valuations

Analysis - 7/26/2017

In short
  • Resurgent corporate profit growth and benign monetary conditions support the case for equities for now
  • We see this period as an extension of the already mature business cycle, not a new one
  • Markets are likely to continue to be characterized by rolling sector rotations until clear signs of the next recession

Equity prices are always a function of corporate earnings or cash flows and the price that investors are prepared to pay for them. Whilst the former is usually relatively easy to forecast and is itself a function of sales growth and margins, the latter is as much art as it is science and depends on a host of interlinked variables, the influence of which tends to change over time.

The good news for investors is that, following a protracted period of earnings stagnation in most regions between 2011 and 2015 (see chart below), corporate profit growth has resumed. In the most recent quarter, year-over-year (y/y) growth registered in the US, Europe and Japan was 10%, 15% and 16%, respectively.



Whilst it is true that, following a period of low growth, expectations were also low and y/y comparisons easier, it has been the gradual and widespread improvement in economic activity in Europe and much of the rest of the world that has been the main driver of corporate sales. As companies are generally in lean condition, these gains have fallen to the bottom line. Also, importantly, this economic growth has not just been in real terms, but, with inflation lifting away from the near zero levels, in nominal terms as well.

Business cycles are more muted these days

Many commentators are keen to argue that, owing to the length of the economic recovery, we must  be due a recession. However, there has been a significant change in the nature of economic cycles in recent decades. This has seen the volatility of GDP, household income and consumption decrease materially. For example, in the US, the volatility (standard deviation) of GDP has gone from 12% in the 1930s, to 10% in the 1940s, to 4% in the 1950s, to 2% in the 1980s, and in the last 6 years has been less than 1%. There have been a number of developments that have brought about this reduction of risk. These include;

  1. the end of the inventory cycle and the advent of “just-in-time” delivery;
  2. the rise of the service sector (which now accounts for 84% of total private sector jobs in the US and 80% of total GDP), demand for which, unlike for manufacturing, is quite stable;
  3. reduced global linkages - to the extent that many services are “non-tradable,” shocks from overseas do not impact the economy as much as many commentators assume, or as much as they used to; 
  4. proactive government fiscal and social policies, including the advent of income-stabilization policies such as unemployment insurance and disability payments. 

The muting of economic cycles in recent decades is vital to understand and, whilst the above-mentioned developments do not preclude the chance of a future recession, they help explain why the recovery from the most recent recession has been modest and why we should expect less extreme cycles going forward.

A preference for European equities

We are retaining our preference for European over US equities. The arguments supporting this include recovering economic growth, relative political stability, more scope for margin and profitability improvement, an accommodative central bank, cheaper share valuations, and an under-owned stock market internationally. Recent economic data has confirmed the constructive backdrop for European shares when there is ongoing confusion about the outlook for policy changes in the US that we feel the market may have been relying on to support profit growth there.

The one potential hurdle that we see for European equities is a stronger euro. Since Mario Draghi recently admitted for the first time that the risk of deflation in Europe had passed, we have seen a sharp move upwards in the European currency. This follows an already improving fundamental backdrop for the euro and an initial strengthening in recent weeks and has led to short-term underperformance of European stocks and exporters in particular. Draghi’s comments are important since the Eurozone has effectively been enduring emergency measures, including negative interest rates and ECB bond- purchasing, for a number of years now.

Sector considerations

This year, there has been a clear performance demarcation between sectors. Growth stocks and the technology sector in particular have been the winners. This has been a global phenomenon and reflects a number of factors. The first is that so  called ‘value’ stocks, including global industrials and financials, had already enjoyed a significant rally post the Trump victory last year. The second is that since December last year, bond yields have either been stable (Europe) or declining (US and UK), reflecting  a decline in actual and inflation expectations as well as more dovish comments from Fed officials. This  has dampened enthusiasm for bank stocks, as well as helping to reinforce the now almost universally accepted view that the Trump reflationary policies would not be forthcoming, at least in 2017. The third is the rising investor interest and conviction that the safest way to guard against the rise of ‘destructive technologies’ on traditional industries is to own those technology shares causing the disruption. Naturally, as investors have sought shares in companies seen as the ‘destroyers’, they have sold shares in those industries that are under pressure.

This trend has been most obvious in the retail sector. Aside from judging the success of the online revolution by observing the stratospheric rise of Amazon’s share price, there are other notable changes that make it fair to say that the bricks-and- mortar retailing industry is effectively in recession  in many countries. In the US, among the general merchandise stores, department stores have been losing sales to warehouse clubs and super-stores since the early 1990s. However, in recent years, both have lost market share to online retailers, who have doubled their share of total in-store and online sales from 15.0% during February 2006 to 29.5% during February this year. Over this same period, the share of department stores fell from 20.0% to 12.4%.

This trend has been as apparent in Europe and in developed Asia and we see little signs that it is due to slow. Indeed, with the news that Amazon is acquiring Whole Foods, there is a threat of a significant increase in competition in the food industry which is already under attack from price discounters such as Lidl and Aldi.

Interestingly, this trend has not only caused problems for department stores but also for shopping malls. In the US, such is the pain that commercial real estate consultants estimate that approximately a quarter (300/1,300) of US malls are at high risk of losing an anchor store. Once the anchor store leaves it has been extremely difficult to get tenants to fill space, and typically mall store closures accelerate after that, driving consumer traffic down, which ultimately sends the whole mall into a ‘death spiral’.

These secular trends are vital for investors to understand and are quite different from cyclical trends such as the potential improvement in net interest margins for banks, courtesy of higher rates. The pace of technological change globally seems to be accelerating, which is bringing productivity benefits to many, but also causing pain to those not adapting to the new environment. Another example is the impact of developments such as Blockchain on banks and other trading companies. We expect Blockchain to be huge and we do not believe the implications are widely understood.

Valuations matter

As we cautioned at the beginning of our commentary, our generally constructive view on equities needs to be set into context. Our philosophy that markets are cyclical leads us to pay close attention to where we are in both the economic / business and interest rate cycles. On the former, companies around the world have witnessed a significant improvement in their situation in the years since the GFC, with default rates declining and margins increasing.

As far as interest rates are concerned, we believe that we are passing through an inflection point such that, whilst we do not expect rates to move significantly higher in this cycle, nor do we expect yields to fall back to the historic lows seen in the middle of last year. In the near term, the potential for an extension of the business and profit expansion gives us cause for optimism that corporate cash flows and profits may not yet have peaked for this cycle. The question is whether all of the positive earnings expectations have already been priced.

Valuing equities is rarely a precise science but historic data is plentiful and we find it useful to set today’s expectations and reality into historic context. The chart below shows the S&P 500 stock market index (top) with the normalized 10-year average P/E below. Whilst there are many critics of this ‘Shiller’ P/E ratio due to the fact that the past 10 years encompass the 2007-2009 recession and the fairly catastrophic collapse in corporate earnings (thereby making the P/E high), we do think that the analysis does a decent job of showing a ‘normal’ cyclical number. As can be seen from the chart, by this method of valuation, the US stock market is at levels of P/E only exceeded in 1929 and 2000!


Obviously, P/Es are just one valuation metric. A quick look at others, including PEG ratios, EV/Sales, EV/ EBITDA, P/B and stock market capitalization relative to GDP, also confirm that, by historic standards, markets are expensive. However, markets can stay expensive for long periods of time and some of the above metrics do not show extreme levels. Moreover, a comparison with bond yields tells a different story. In the US, for example, the dividend yield of the S&P 500 has been around 2% since the mid-1990s. This tells us that the index has been growing at the same trend of dividends, which is around 7% a year. What is different is that, in recent years, the dividend yield is approximately the same level as the US 10-year yield, which has not been the case since the 1950s. The inflation premium that bond investors have historically sought has gone, signaling that investors apparently believe inflation is dead. With both yielding around 2%, stocks look cheap.

Investors must therefore assess other aspects of the market, since high valuations do not by themselves indicate an imminent market correction or bear market. But they do signal that the risks around owning equities are raised and that disappointments are likely to be taken badly.

Richard Beggs
Global Head of Investment Strategy
Private Banks Investments & Advisory
Edmond de Rothschild


This analysis is an extract from the first House View published by Edmond de Rothschild. 

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