For the last few years of this bull market we have been told that equity markets are too expensive and any further rises would be irrational, only for markets to defy the commentators and set new all-time highs. So are markets actually too expensive?
Valuations are not stretched:
Cyclically Adjusted Price Earnings Ratio (CAPE) is often used to explain why markets are expensive. However, CAPE has its flaws. Because it looks at the average earnings over the past 10 years it has been misleading investors. This figure puts earnings much lower as the figure incorporates the global financial crisis and the subsequent years when earnings per share were substantially weaker than normal.
Forward looking Price-Earnings (P/E) ratios don’t suffer from this and do not point to markets which are extremely overvalued. In the US the Forward P/E is 18.7 compared to historical P/E ratio of Ratio 22.8 and a CAPE of 34.
Only three of the top 50 largest S&P 500 companies have a P/E ratio of over 50 compared to 14 back in 2000 at the peak of the dotcom bubble.
Bull runs don’t die of old age:
Investors are concerned that with markets currently in the second longest bull-run in their history, something has to give and soon. However, as is often said, bull runs do not die of old age. Given that this bull market has been during a period of weaker GDP growth and perhaps more importantly has been supported by loose monetary policy, low interest rates and very accommodative central banks there is no definitive reason why the run can’t continue. Each bull market is unique.
Earnings forecasts for 2018 are not excessively high:
At present, earnings growth forecasts for this year are actually coming in lower than we saw in 2017. In Europe earnings growth is expected at about 9 per cent versus the 12 per cent we saw last year. This means there is more potential for positive surprises which would support stock markets.
Fiscal stimulus and tax reform:
The tax reforms in the US could provide a significant boost to the economy. Initially this money was expected to just pass straight to shareholders and the wealthy so not enter the economy and have little impact. However, the likes of Walmart and Apple have announced they would give each of their employees a bonus of $2,500 (in stock) and up to $1,000 respectively. This is largely going to lower income families and is likely to get spent and could provide a significant boost to the economy.
The tax cuts and fiscal stimulus are estimated to add between 0.3 per cent-0.8 per cent to GDP and could boost earnings per share by nearly 15 per cent. Analysts are now expected to raise their GDP forecasts for the US higher for 2018.
The global economy is healthy:
US business confidence is high with the latest PMI Business Confidence at 59.7 and no reasons for it to fall. When this figure is above 50 the S&P 500 generally rises.
There is plenty of capacity for growth with unemployment still high in Europe. While in the US and UK there is room for productivity improvements which would drive further growth in those economies.
There are also clear signs that capital expenditure, Capex, is rising which is supportive of economic growth and improved productivity.
Investor sentiment is a harder factor to measure, but anecdotally there are clearly a large number of investors who remain nervous of this bull market and are expecting a correction, or doubt the data in front of them. Bubbles appear when there is exuberance in markets and the number of bulls outweigh the number of bears by a significant margin driving markets even higher.
Adrian Lowcock is investment director at Architas.
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