World equity markets are on a tear, driven by synchronised global economic growth – on track to expand by 3.6% this year, the fastest rate in six years. The world index hit a new high in September and the US market experienced its first 8-quarter winning streak in 20 years. And in spite of a wide range of negative geopolitical events and valuation levels that are well above historical averages. [CHART 1]
To put in perspective just how elevated valuations are, we can look at a number of the most widely used valuation measures in the industry (US market):
Source: Merrill Lynch
It is apparent from the above, that valuations (pretty well across the board) point to a market which is stretched – perhaps not yet in bubble territory, but extended nonetheless. In terms of the key forward p/e metric, a reversion to the average would cause a 15% pullback. Severe, but hardly in nosebleed territory – although, on trailing p/e’s, the over-valuation is far higher at 25%.
The robust global economic backdrop and IMF GDP growth forecasts [CHART 2] are clearly a powerful influence, but another key reason that world markets have been able to grind steadily higher, despite these demanding metrics, is the low interest rate environment. With cash yields close to zero (and negative in many countries) and bonds offering not much more, the hunt for yield (pension funds, retirees, et al) has kept investor funds flowing into equities.
A key metric, not highlighted in the above overvaluation table, is the one measure which is positive: the relationship of dividend and earnings yields to long term interest rates. In the US, the S&P 500 dividend yield is 2.0% which is just below the 10 year Treasury yield of 2.3%. [CHART 3] At present, dividend yields are close to that offered by the 10 year yield – currently at 85% of the long term yield, well above the long term average of 60%.
Perhaps even more relevant, is the relationship of the earnings yield to the Treasury rate, as this represents the actual return you derive from investing in a company: profits not paid out as dividends are reinvested in the business on your behalf to generate future growth. The earnings yield is currently 4.9% – more than double the 10 year yield and well above its long term
relationship. [CHART 4] Interesting to note, that for most of the 90’s the earnings yield was below the 10 year yield. Now it is well above. With both the dividend and earnings yields offering historically much better relationships to long term interest rates, there is a strong case for remaining in equities. And, of course, both earnings and dividends will grow over time making the case for equities even more convincing.
If investors could be sure that interest rates will stay low for a prolonged period, this would provide a powerful counter to the raft of other measures which are raising red flags. While interest rates will rise in due course, current indications are that long yields will remain relatively low for some time yet. Until global growth and earnings slow sharply (as they inevitably will), equities should retain their relative attractiveness over bonds, notwithstanding their greater volatility.