Thursday, 18 April 2013

Valuation bears – one born every minute

Photo: Hamed Saber

Given that my partner and I are now in the final trimester expecting our second child, just as with the first, I am now being ‘encouraged’ to watch Channel 4’s weekly show, One Born Every Minute. For those who have not seen it, the show explores the birthing experience of everyday couples across the UK. To demonstrate my compassionate side, and to acknowledge my admiration of what my better half is about to go through, of course I oblige. Given we have Sky plus, missing Celebrity Pet Swap has also become less of an issue.

Without wanting to spoil the fun, the show runs to a familiar path. Initially we are presented with an adorable loving couple, whom we are immediately compelled to route for. Then, as we go deeper into the story (typical in theatre), things get a little worrying. In the end, however, we are rewarded with a thoroughly gratifying outcome as parents finally cradle their new bairn.

I highlight this because I believe (believe it or not!) the journey of watching One Born Every Minute is very similar to the current experience of investing in US equities. How is this so? Well, for some time this blog has discussed the compelling story of the US economy, paying particular attention to the ongoing recovery in the US housing market and its industrial renaissance. As we go deeper into the story, however, and in particular looking at stock market valuations, one might start getting a little concerned. In the end, however, and despite the heightened anxiety valuations may bring, we are hopeful of a rewarding outcome.

This blog will try to underline why we believe valuations, and in particular ‘cycle-adjusted’ valuations, are not quite as frightening as they may first appear, and why we remain positive on the US stock market.

For those less familiar with the various equity market valuation techniques, Price to Earnings (P/E) measures the multiple investors are paying for a year’s earnings. For example, a company with annual earnings of $1 per share, trading at $10, is considered to have a PE of 10x.

This relatively crude measure pays no consideration to the fact that earnings are heavily influenced by where we are in the economic cycle. For example, if we are in the depths of a recession we would expect prices to fall and earnings to recede. However, upon recovery we would also expect the figure to normalise (move higher). Should $1 of ‘recessionary’ earnings move to a $2 figure in normal economic conditions, a ‘normalised’ P/E ratio of 5x ($10 price divided by $2 normal earnings) might be the more appropriate rating. Such a move would also render the company not quite so optically expensive.

Conversely, if we are in the midst of a boom, prices are likely to be rising and earnings with them. As a result, one might expect authorities to undertake tightening measures and, therefore, for earnings to normalise at a lower level. Using the above example, if $1 of earnings were delivered during a ‘boom’, then more normal earnings might be 50cents per share. The P/E ratio therefore, would register at 20x rather than 10x. This adjustment would leave the company looking decidedly more expensive.

One valuation method that accounts for this volatility in earnings, and that attempts to normalise the figure, is the Cyclically Adjusted PE Ratio or CAPE Ratio. This ratio is based on the average inflation-adjusted earnings from the previous 10 years, hence why it also know as PE 10.

This method was deigned by Robert Shiller and is discussed in much greater depth in his famous book ‘Irrational Exuberance’. The CAPE Ratio for the S&P 500 going back to the late 19th century is shown below.
Source: http://www.multpl.com/shiller-pe/table
With roughly 150% total return delivered by the S&P 500 since its trough in early 2009, investors are right to question whether valuations remain supportive of a bullish view. Indeed, further analysis of the CAPE ratio may well lead you to a rather worrying conclusion – that US equities are ‘over-valued’. The CAPE ratio currently sits at around 23x, with the long term average at about 16x. According to this measure, therefore, it would take a 30% correction in US equities to bring us back to ‘fair’ value.

Why then, with this challenging valuation backdrop, do we remain positive on US equity markets? The over-arching belief is that profit margins, though cyclically high, are sustainable. The lower earnings figures delivered in the less positive phases of the current economic cycle should, therefore, be awarded less importance.

Why do we believe profit margins are sustainable? There are four major arguments supporting this view.

1. Cost of debt
The US central bank is providing increasingly transparent guidance on when interest rates may rise. 6.5% unemployment has been ear-marked as the figure likely to trigger a review, though there is no commitment to hike when this level is achieved. Current predictions are for 6.5% to be attained by early 2014 – though this date will likely be extended on the back of recent disappointments in the payroll data.

2. Wages
Given the level of unemployment still plaguing the US economy, employees are still on relatively weak grounds in wage negotiations.

3. Reduced energy costs
Again, something that has been discussed at length is the US shale gas boom and, in close pursuit, shale oil. Cheap energy costs keep manufacturing costs down, supporting profits.

4. Continued recovery in housing
The US housing recovery continues to gather steam. This raises household wealth, boosting consumer confidence and increasing their propensity to spend.

With government spending cuts now starting to bite, it could be that we are entering a period a softer US economic data. High gasoline prices are also likely to crimp consumption demand, and a stronger dollar may dampen overseas earnings performance. It could well be, therefore, that stock markets suffer a few wobbles over the summer, and investors have to take a little bit of pain. Not quite to the extent of childbirth, but uncomfortable nonetheless!

All in all, however, whilst we acknowledge the CAPE figure rightly raises a ‘yellow flag’, there are sufficient grounds to stay the course.

Ben Gutteridge
Divisional Director - Research

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