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Article | 21 February 2018 | Investments
For the last few years of this bull market investors 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 more all-time highs. So despite the higher volatility since the start of the year are markets actually too expensive?
Those worried about markets rising further often start with valuations and yes on some metrics the markets do look expensive. On the Cyclically Adjusted Price Earnings Ratio or CAPE, the S&P 500 is trading at levels only seen during the great depression and dotcom boom.
However, the CAPE measure needs to be put in context to avoid misleading investors. The figure looks at the average earnings over the past 10 years. This means that it takes into account the financial crisis and subsequent years when corporate earnings were very low. This has the effect of distorting the figure, making it higher than would otherwise be the case. As such it is useful to also look at the Forward P/E Ratio which for the S&P 500 compares favourably with the historical average of the market.
The length of time the bull market has been going has also got investors nervous. It is important to remember that 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.
Usually analysts are overly optimistic and therefore overestimate future earnings growth. But forecasts for this year are actually coming in lower than we saw in 2017. Whilst not a definitive reason markets aren’t expensive, it doesn’t imply that investors are getting over-excited and remain more cautious.
Tax reform provides a boost
The US tax cuts are estimated to add between 0.3-0.8 percent to GDP over the next ten years and could boost earnings per share. Analysts are now expected to raise their GDP forecasts for the US higher for 2018 which should provide a boost to stock markets and indeed may have already done so.
US business confidence is high with the latest ISM Manufacturing PMI at 59.1 and no reasons for it to fall. When this figure is above 50 the S&P 500 generally rises. And it’s not just the US in Germany confidence is at the highest levels in years.
There is also 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.
Perhaps the most important thing is that capital expenditure, Capex, is now returning which is supportive of economic growth as well 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.
The global economy is in fairly good shape and the tax reforms in the US should mean the economy there continues to grow which is good for the global economy. Nine years after the financial crisis, companies are only now just beginning to feel confident enough to invest again – a boost to capital expenditure should help improve productivity which feeds back into company profits.
It is very hard to predict when a market might turn and the causes of a correction or change in sentiment are only obvious in hindsight. As such it is more important to focus on what we do know and stop trying to time the market. Investors would benefit from focusing on the long term, as stocks markets have tended to rise over time.
At the same time it is important to be prepared, corrections of 10% or more are not uncommon and it is better to be prepared for such corrections and be diversified as this helps protect your investments.