Are markets already too expensive?

Market allies

Since the Federal Reserve (Fed) cut its policy rates in September, the markets appear to have been buoyed by renewed enthusiasm. Of course, this isn't solely a reflection of the Fed's decision to cut rates further than economists had anticipated; the joint stimulus plan of the Chinese government and central bank has also played a significant role. To summarise the current situation, the Fed and all the central banks of the G10 countries have transitioned from being adversaries to allies of the markets. Growth has shown signs of improvement, and China, which has been lagging behind, seems poised to regain some of its vitality. In other words, some of the markets' concerns have dissipated, leaving valuation as the primary constraint. The pressing question now is, are the markets already too expensive? If not, what can be said about their potential upside? Our multi-asset valuation signals can provide some interesting insights on this topic.

Positive disappointment

The consensus for September was clear. Historically, markets tend to decline in September: on average, the MSCI World index fell by almost 1% over the last 30 years, with 12 of these years showing a bearish hit ratio, surpassed only by August (16/30). Consequently, the month of September, particularly the latter half, was expected to aggregate the sum of all fears, with an anticipated plunge in the markets. Unfortunately for forecasts, but fortunately for portfolios, equities rose by almost 1%, driven by a significant portion of the stock market.

This robust momentum is clearly evident in Figure 1, which shows the percentage of stocks traded on US markets that are above their 200-day highs: nearly 65% these days, a historically high figure. Another indicator of this renewed momentum is that the S&P 500 equal-weighted index delivered performance in September close to that of the market cap index. Is this enthusiasm for equity markets widespread? Not entirely: our 'in-house' risk appetite indicator, also displayed in Figure 1, places it at around 50%, halfway between bull and bear. The demand for hedging, as reflected in this indicator, indicates some lingering mistrust among investors, a legacy of the rise in risk aversion at the beginning of August. The two indicators shown in Figure 1 have generally aligned over the past 18 months, but this time they diverge. If the equities craze prevails in this tug-of-war, what further upside potential do the markets possess?

FIG 1.  Market-based risk appetite and percentage of stocks above their 200-day highs (NYSE)

Source: Bloomberg, LOIM, as at 26 September 2024.

Room for Improvement

It's always challenging to judge the upside potential of financial markets at any given time, as valuation signals are complex to construct. Nevertheless, we have recently taken up this challenge by creating a valuation overlay, which we've implemented in our portfolios this year. This overlay is based on the simple idea of breaking down asset prices into a ‘trend’ part and a ‘cycle’ part. The latter expresses the over- or undervaluation of markets in relation to their trend. Defining overvaluation limits allows us to assess how expensive these assets are.

Figure 2 presents an estimate of the progress required for each asset class to reach this overvaluation limit—to be able to declare these asset classes ‘too expensive’. It reflects two different calculation methods: one based on an analysis of the entire historical trajectory of asset prices (i.e., longer term) and the other on the last five years (shorter term). The final measure combines both on an equal footing. According to our calculations, developed equities have a growth potential of close to 15%, but commodities are the most attractive in this context, with a growth potential of 30%. Credit is close to its high-water mark. The key point here for the reader is to understand that, according to our indicator, there is still room for improvement as the year draws to a close, despite already very positive performance. Nevertheless, the upcoming US elections could introduce a degree of volatility over the coming weeks—enough to keep us on our toes until November.

FIG 2. Performance to be realised by asset class to reach the expensiveness limit in our multi-asset valuation signals

Source: Bloomberg, LOIM. For illustrative purposes only.

What this means for All Roads

This shift in market tone has already impacted our strategy allocations. Although the valuation overlay is currently inactive, with no market currently flashing red, the rest of our process has led us to increase our market exposure, which now stands at 160%¹. This increase in investment has been primarily in cyclical assets, reflecting reduced volatility, more distinct trends and improving macroeconomic signals. The issue of pricing will eventually surface, but that appears to be a concern for later.

Simply put, if market valuation is a cause for concern, there still seems to be room for improvement.

Macro/nowcasting corner

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

Our nowcasting indicators currently show:

• Growth signals continue to get better, with this week's figures showing 59% month-on-month improvement
• Inflationary pressures continue to rise, with this week 63% of data up in the Eurozone and 67% in the US
• Our monetary policy signals eased over the week, with the US indicator at 40%, in line with the Federal Reserve's dovish communication

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).