Quo vadis, equity markets?


Yves Ceelen, Head of Institutional Portfolio Management, explains in this article the main valuation metrics in order to assess the equity markets development and draws some conclusions on the outlook for this asset class in the medium to longer term.

The year 2018 ended with equity markets falling sharply and spooking investors across the globe. In December, the S&P 500 fell almost 10%, while the Stoxx 50 and the Nikkei decreased by 6 and 10% respectively. This market turmoil has left many investors wondering: are equities on the way down or is this is an opportunity to buy the dip?

The business cycle

A first step in solving this conundrum might be investigating at which point of the business cycle we find ourselves today. The length of the current economic expansion raises the suspicion that we might be approaching the end of the cycle. Currently in its 114th month, this expansion is already the second longest expansion in history, closing in on the economic upturn that started in March 1991 and lasted 120 months. This is the result of extremely loose monetary policy (low and even negative interest rates, QE, LTRO, yield curve control) as well as recent fiscal policy by the US and the Chinese administration.

However, as former Chair of the US Federal Reserve declared, expansions do not die from old age, rendering a deeper analysis of the business cycle necessary. Economic and market indicators offer us more information. Leading economic indicators, such as the purchasing managers’ index (PMI), which typically lead the business cycle, seem to have peaked late 2017 to mid-2018. Lagging economic indicators such as the unemployment rate are still showing positive readings, pushing central banks to further tighten monetary policy. Economic indicators therefore show that the end of the expansion may be reached. This conclusion is reinforced by the Fed’s apparent intention to pause its hiking cycle and a US yield curve that is already partially inverted.

Economic and market indicators, as well as policy makers such as the Fed, are pointing to the same conclusion: we may well be at or beyond the top of the business cycle. This begs the question: quo vadis, equity markets?

How to value equity markets?

In order to estimate the direction of equity markets, an investor should assess current equity valuations. The price-to-earnings ratio (PE) is probably the most widely used metric by financial analysts and strategists. This metric works very well in trending markets but has one important flaw. At turning points in the business cycle, most companies, analysts and strategists tend to extrapolate the trend in underlying earnings at the moment the latter reverses direction. As such, the valuation metric gives the wrong signal. The signal is too bearish near market and economic troughs and too bullish near economic peaks. As the current business cycle is approaching its final stages, the PE ratio therefore is unlikely to be the most appropriate tool to use.

Rather, to put equity valuations in a larger perspective, it makes sense to either avoid extrapolation of the denominator in the equation (earnings per share) or use another metric that has become more popular in recent years, inspired by Robert Shiller, Professor of Economics at Yale University. This Nobel Prize winner created the cyclically adjusted price-to-earnings ratio, commonly known as CAPE or Shiller PE. This valuation measure is defined as the price divided by the average earnings over the past ten years and adjusted for inflation. Simply put, it takes into account earnings over a ‘full’* business cycle in order to take out much of the cyclicality in earnings figures, and in doing so trying to avoid excessive extrapolation into the future.

Evaluating the CAPE for the different equity regions and putting the current figures in a historical perspective might help to answer many questions investors currently face: Are markets cheap after the current fall in equity prices? Has a recession already been priced in?

Let us start with the denominator first. Graph 1 shows the evolution of the earnings per share. Earnings growth since 2006 has been the strongest within emerging markets followed by a revival of Japan and then the US. It is painful to see that earnings growth in the Eurozone was almost non-existent as a result of the heavily regulated sectors like utilities, communication services and financials that saw their earnings decline ferociously.

Graph 1 – Earnings per share evolution since 2006

Source: Factsheet

The graph below shows CAPE for the different regions in a historical context. All three regions included saw CAPE ratios rolling over lately after the market fell abruptly during the last quarter of 2018. On a relative basis, US valuations are still richer than counterparts of the Eurozone and Japan. Compared to their own history, the US remains rather expensive (26% above its average) as does the Eurozone (23% above its average).

All measures have their flaws. Indeed, CAPE multiples would automatically come down slightly next year as bad 2009 earnings figures drop out of the 10-year moving window in the denominator. This being said, earnings expectations for the next few years do seem overly optimistic in a lower growth environment

Graph 2 – CAPE for the 3 main regions

Source: Factsheet


From the analysis above, two conclusions can be drawn.

First of all, investors should be somewhat prudent on European and US equity markets over the long term. Even after the recent decline, these markets are not yet cheap. Certainly, they are not pricing a recession. Japan on the other hand seems fairly valued and thus more interesting from a valuation point of view.

Secondly, earnings growth in Europe has been dismal for a decade. There are no immediate signs that this picture will change for the better anytime soon. This does not mean that Europe should be cast aside, but rather that active management is vital within European equities in order to generate decent future returns.

*Including the current expansion, the average expansion since 1854 lasted 41 months. After 1945, the average length amounts to 64 months. (NBER)


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