How expensive are valuations?

Has the market rally in equities and credit spreads reached excessive levels this year? How should risk-based investors position? Using LOIM’s new cross-asset valuation metric, this week’s Simply put considers the state of valuations and finds a surprisingly nuanced landscape.

 

Need to know: Equities and credit spreads have performed well since the start of the year, fuelled initially by central banks shifting towards rate cuts, and subsequently by a robust earnings season that reflected a solid macroeconomic environment Despite significant gains, our analysis indicates that the market rally is not uniformly extreme: while global equities have realised much of their anticipated returns, opportunities remain, particularly outside the US, in our view Our in-house, cross-asset valuation metric suggests that although equity indices are currently expensive, they have not reached excessive highs. We position our All Roads strategy to balance growth potential with risk management

 

Strong performance so far

Since the start of the year, the performance of equities has been remarkably robust, while credit spreads have tightened significantly. The primary catalyst for this strong performance was central banks shifting away from a decidedly hawkish outlook towards a readiness to loosen policy. The Swiss National Bank (SNB) and the European Central Bank (ECB) proceeded to deliver rate cuts, although the Federal Reserve (Fed) did not follow suit.

Beyond this initial stimulus, cyclical assets surged and performed positively. The main driver for the second surge was the strong earnings season, which reflected the resilient macroeconomic backdrop.

However, the proverbial ‘trees don't grow to the sky’ – which indicates natural limits on growth – may now come into play as various market observers are beginning to advise more cautious exposure to risky assets. Our signals, however, disagree with this caution. This week’s Simply put shares a detailed reading of these signals from our new valuation cockpit.

 

Is the rally overextended?

The simplest method to assess whether a market rally is overextended is to compare the expected returns from a forecast scenario against the actual performance. As shown in figure 1, this comparison uses the expected returns we projected at the end of 2023. These projections were based on a few key assumptions: a soft economic landing, ongoing disinflation and a pivotal shift in central bank policies. Under these conditions, we anticipated that global equities could yield about 11% in 2024.

As of the end of May 2024, much of this gain had materialised, with a nearly 9% increase already recorded. However, it's crucial to note that a narrower-than-expected segment of the market drove this rally. In particular, European and emerging market (EM) equities have only realised about a third of their anticipated returns so far. From this perspective, diversified investors like ourselves see further potential for the rally – it's far from over, and the real opportunities may lie outside US markets, suggesting a strategic pivot in investment focus might be warranted.

 

FIG. 1. Expected returns for 2024  versus actual performance at 30 May 2024 and points of comparison

Source: Bloomberg, LOIM Core figures. As of 30 May 2024. Subject to change. Past performance is not an indicator of future returns. For illustrative purposes only.

 

What do price-to-earnings ratios say?

The concept of calendar performance in asset management often raises a curious question: why should asset performance adhere to an annual calendar? This arbitrary timeline can sometimes skew perception and valuations.

A more nuanced approach to evaluating equities involves turning to timeless, scenario-independent metrics such as price-to-earnings (PE) ratios. Figure 2 illustrates the recent evolution of PE ratios across major indices that compose our equities allocation. The data suggest that while PE ratios are currently on the higher side, they have not reached excessively elevated levels.

Furthermore, it's noteworthy that the PE levels post-earnings season are lower than at the beginning of the year. This indicates that markets have appreciated since the start of the year, but not as significantly as earnings . We believe this lack of substantial, multiple expansion makes it difficult to deem the equity market as overly expensive at this juncture.

 

FIG. 2. Price-to-earnings ratios

Source: Bloomberg, LOIM. As of 30 May 2024. Subject to change. For illustrative purposes only.

 

It’s all relative: an innovative cross-asset tool

We have recently developed a novel type of cross-asset valuation metric designed to assess the relative expensiveness of all assets and risk premia integrated within our strategies. This innovative signal evaluates the current level of any price index against a composite of its values over the past two years. Intrinsically, the distance between the current price and this historical amalgam is designed to be mean-reverting at a low frequency – capturing the fundamental nature of a valuation measure.

Figure 3 illustrates this metric applied to the most traditional assets in our investment portfolio. The insights drawn from this analysis align closely with those observed in figure 2: a negative reading on this new metric suggests expensiveness. Currently, most equity indices appear expensive from this perspective. However, this level of richness has not yet crossed into the realm of what might be considered overextended. While figures 1 and 2 indicated some variation, here, in contrast, European stocks (notably the Eurostoxx index) register as expensive, approaching the extreme threshold. Yet, consistent with the earlier figures, EM equities do not appear overly expensive, suggesting a nuanced landscape across global equity markets.

 

FIG. 3. LOIM Cross-asset valuation indicator

Source: Bloomberg, LOIM, as at 10 June 2024. Subject to change. For illustrative purposes only.

 

What this means for All Roads

The current positioning of our All Roads strategy remains tactically exposed to cyclical assets while maintaining a defensive posture towards duration. As such, the issue of expensive cyclical assets is pivotal. Our ongoing research efforts have led us to refine our strategy and implement a valuation overlay in June. This new overlay currently favours adding duration over reducing equities. The adjustment reflects our proactive approach to balancing potential growth opportunities with risk management to ensure that our portfolio remains robust in varying market conditions.

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Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises is designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

• Growth remained stable over the week. It is currently indicative of slower economic conditions than before, a factor that should prove supportive of the Fed and of the ECB in their fight against inflation
• Inflation surprises continue to progress. Their progression this week was fuelled by both US and European data. With that, Q3 could see higher inflation than anticipated
• Monetary policy signals remained stable over the week. Their current message is: next step is a cut, but maybe not today

  

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

 

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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