Investors are failing to give themselves a decent margin of safety as current market prices drift further from the underlying fundamentals of stock valuations, said Schroders Andrew Williams.
Williams, a member of the Schroders value team, said the actions of many market participants suggested that there was a lack of caution, which is something investors should be aware of.
“As things stand, investors could be forgiven for thinking pretty much everything is in a bull market,” he explained. “Fuelling the fire is ever cheaper debt and a general ability to access money more easily. Data meanwhile shows both companies and households are increasing borrowing levels.”
Instead Williams said investors should focus on underlying valuations.
The Schroders’ Value team favours the cyclically adjusted price/earnings ratio – CAPE – as a way of valuing companies. The metric shows the average earnings generated by a market over the last 10 years, adjusted for inflation.
“In order to value the future earnings you can expect from owning shares in a business, you need to discount them by reference to an interest rate,” he explained.
“The modern-day cry of ‘this time it’s different’ has stemmed from the expectation real interest rates will be lower for longer.”
Williams said the low interest rate environment had made the outlook for future earnings more desirable and justified higher share prices.
He added: “A world of historically low interest rates has thus led to higher and higher CAPE numbers and yet the more investors are prepared to pay up for a stock, the more risk– whether they recognise it or not – they are taking with their money.
“In short, they are failing to give themselves any margin of safety – a mistake value investors work hard to avoid making.”
Higher valuations have raised concerns among investors. Indeed, markets have shrugged off many of the geopolitical headwinds and continued to advance.
Performance of S&P 500 over 10yrs
Source: FE Analytics
For example, just over a decade since the onset of the global financial crisis the S&P 500 has continued to grow – albeit at a slower rate more recently – growing by 106.82 per cent over 10 years.
Currently the S&P 500 is trading with a CAPE ratio of 31x, Williams said, adding that the US blue-chip index has only ever been more expensive on two previous occasions: just before the dotcom bubble burst in 2000 and in the build-up to the Wall Street Crash of 1929.
“The fact its long-term average – using data stretching back to 1881 – is 17x would suggest investors are currently willing to pay an unusually high price for shares,” said Williams.
“Over time, like so much else in investment – and indeed in life – any CAPE will tend to head back towards its longer-term average,” he added.
“Looking at the S&P 500’s elevated headline figure of a little over 31x today, therefore, some would conclude this ‘mean reversion’ implies an imminent correction to asset prices – and, of course, this remains a very real possibility.”
While the US market continues to move higher and trade at expensive valuations relative to history, in the UK a slightly different picture emerges, said Williams.
He said: “Moving closer to home, it is fair to say that, while in aggregate the UK market is not as expensive as the US, it is no longer cheap.”
Yet, Williams said despite the FTSE All-Share moving higher, CAPE ratios have remained lower than in previous market cycles.
He explained: “Almost two decades of earnings growth do mean that, despite today’s index level being higher, valuations are not as overextended as they were in 2000 or 2007.”
Source: Schroders
“At those two earlier peaks, the FTSE All-Share traded on a CAPE of 28.6x and 22.1x respectively whereas, despite the higher index level, its CAPE today is closer to 17x,” he said.
“That is still well above the long-term average of 11.4x – UK stock market data goes back to 1927 – and history suggests that, from today’s valuation level, the wider UK market will deliver inflation plus 3 per cent to 4 per cent a year for equity investors over the next decade.”
Williams said it was worth noting that the growth rate implied by current valuations compares with inflation plus 7-8 per cent “over the very long term”, although it remains impossible to make accurate forecasts about future performance.
“Equally, it is important to bear in mind any market valuation is simply an average of the value of the individual stocks within it and, among those individual stocks, there remain some attractive opportunities for value-oriented stockpicking investors,” he said.
Williams added: “It is these opportunities that give us confidence in our ability to continue to extract the 2 per cent or so premium return offered to value investors over and above the market itself, through focusing on the cheapest parts of the market.
“Relative to some competitors, who are increasingly overly exposed to expensive companies, we believe the outperformance from our own portfolios should be significant.”