• Stonewood AM

Valuations Seem Off...

In all assumptions around future returns and asset class behaviour you need to start with asset class valuations. If something is undervalued or trading below its intrinsic value over time you would expect it to appreciate to fair value or generate an excess return in relation to expectations.

The opposite could be true for assets trading above fair value/intrinsic value. These assets, in theory, should return below average results or even losses over a given period assuming the market realises what the fair value is.

We often look to long term averages and historic asset class performance from specific valuation starting points to determine what a reasonable return expectation could be going forward.

Let me use US equity as an example with the CAPE Shiller Price Earnings Ratio. The CAPE Shiller PE Ratio is a well-accepted measure or valuations. Using the image below it plots the 10-year return based on the starting Shiller PE Ratio (price to earnings ratio) The chart on the right is really important in terms of this point.

Going into 2020 the CAPE Shiller PE ratio was above its long-term average sitting at of around 31x, 25x is the long-term average, before COVID-19. If you look at the 10-year future expected return on a 31x ratio, history tells us returns should fall between the 0%-5% per annum bracket. Now long- term US equity return expectations are normally in the 5%-10% per annum bracket, and when US stocks are considered cheaper than average return expectations jump through the roof. CAPE PE Ratios of below 20x have generally resulted in returns of over 10% per annum.

Using the CAPE Shiller PE ration as a proxy for valuation going into 2020, 10-year future return expectations on US Equity would be fairly low and probably not be the reward that investors tend to expect.

Source: Robert Shiller, Irrational Exuberance

Post the COVID-19 fallout and the recent rebound in equity prices the Shiller PE Ratio currently sits at 27x (at the time of writing), which is still above the mean and therefore still points to reduced return expectations going forward assuming historical valuations are a good guide.

Despite the recent COVID sell-off experienced, and the recent rebound in stocks, the US equity market is down only around 10% for the year. Making the long-term valuation assessment of the entry point, not much more compelling than it was before COVID-19.

The same can be said about many equity markets across the globe albeit most others are closer to average long-term values than the US. Emerging Markets are perhaps an outlier in that they are in “cheap” territory but have been more attractive based on a relative valuation for almost a decade with no mean reversion.

Which does point to the obvious conclusion that this entry point and 10-year forward return guidance is not accurate 100% of the time but does give investors a good view of how things have behaved historically.

Read on... Have Markets Recovered?

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