Most investors believe developed market equities are now too expensive, the closely watched latest CFA UK Valuations index shows, suggesting that the record highs being seen in stock markets could be under threat.
2016 ended with the FTSE 100 reaching a new record after closing at 7,142.83 following a ‘Santa rally’ across December. The blue-chip index also ended the first two sessions of 2017 higher (and breached the 7,200 mark at one point on Tuesday) and ended today at 7,189.74.
Despite events such as the Brexit result and Donald Trump’s US election victory, 2016 was a strong one for equities. The FTSE 100 was up by 19.07 per cent in total return terms and the developed market-focused MSCI World index rose 28.24 per cent; both were surpassed by the 32.61 per cent gain (in sterling) in the MSCI Emerging Markets index.
Performance of indices over 2016
Source: FE Analytics
However, the most recent CFA UK Valuations index – which surveyed the analyst and investor members of the CFA Society of the UK between 28 November and 7 December 2016 – shows that many are now convinced developed market equities do not represent fair value.
Some 71 per cent of respondents now say developed market stocks are overvalued, up from just 40 per cent at the start of 2016. This is the highest reading in the index’s history.
Meanwhile, the proportion of investors who view developed market equities as undervalued has fallen from 27 per cent at the start of last year to just 10 per cent today.
Will Goodhart, chief executive of CFA UK, said: “The fact that more than 70 per cent of respondents say that developed market equities are overvalued indicates that the so-called ‘Santa Rally’ might be running out of steam.”
“With so much change occurring in 2016 and potentially 2017, it seems investors are concerned a lot of the positives may already be in the price. They could be reluctant to chase further gains.”
What’s more, the strong rally that was seen in emerging market equities during 2016 – prompted by recovering commodity prices and signs of better economic fundamentals – left a growing number of investors seeing this asset class as overvalued.
Over 2016, the proportion of investors considering emerging market equities to be overvalued climbed from 19 per cent to 25 per cent. However, the consensus is still that this part of the market is undervalued as 43 per cent of respondents hold this view.
CFA UK Valuations Index for Q4 2016
Source: CFA Society of the UK
As the chart above shows (where green represents a perception that an asset is overvalued and blue that it is undervalued), fixed income remains where investors have the most concerns about overvaluation.
The survey found that 78 per cent of investors consider both government and corporate bonds to be overvalued at their current levels. In contrast, only 6 per cent say they are undervalued.
When it comes to gold, investors were split with one-third each saying the safe haven asset is overvalued, fairly valued or undervalued.
Goodhart says that the combination of the above suggests 2017 is likely to be a difficult year for investors to navigate easily.
“2016 was a year of significant political shocks, but markets have weathered these well with continuing accommodative support from central banks through most of the year.”
“Our survey respondents now believe developed market equities to be at their most overvalued level in four years, suggesting that they worry that some of the risks that the markets have shrugged off to date may come home to roost,” he explained.
“Rising bond yields appear to have removed one of the few remaining reasons to regard equities as undervalued. The Fed's December rate hike and the announcement of more to come in 2017 should mean that bond valuations back down. 2017 is looking like a year where investors should tread carefully.”
Signs that investors are rotating out of more expensive areas of the stock market into cheaper parts were highlighted 2016 after value started to outpace growth, following several years of significant underperformance.
Global sector sentiment (% saying overweight - % saying underweight)
Source: Bank of America Merrill Lynch
The above chart, which is from the latest Bank of America Merrill Lynch Global Fund Manager Survey, shows asset allocators were rotating out of growth sectors like technology and ‘bond proxies’ such as utilities, telecoms and consumer staples to move into value areas including banks and resources.
Given that quality growth and ‘bond proxies’ have driven stock market returns over recent years, the rotation out of them could present many funds with problems as their previously strong performers come under pressure.
David Jane, manager of Miton’s multi-asset fund range, warns that this move away from expensive parts of the market towards cheaper, more cyclical parts looks set to continue.
“We expect the huge rotation out of ‘bond proxies’ and into more cyclical industries will continue, as the long bull phase since 2009 has been driven primarily by the revaluation and leveraging of otherwise dull industries, such as consumer staples and tobacco.”
“We now expect a period of stronger economic growth and, hence, sales and profit growth from all those equity sectors which have been left behind,” he said.
“We think that next year will be more driven by industry sectors than regions, as old leaders continue to lag as bond yields rise while economically sensitive laggards such as industrials and financials take up the running. These areas are where the value is and many of the headwinds have been removed in recent months.”