Few investors could have missed the return of volatility to stock markets in 2018 but many markets continue to look expensive even after the sell-offs that have been seen over the past few months, various valuation metrics suggest.
While 2017 handed decent gains to investors with historically low levels of volatility, things have been very different in 2018. As the chart below shows, all the major equity markets ended the first quarter of 2018 in negative territory, in sterling terms.
The FTSE 100 came off worse, falling 7.21 per cent by the end of the three-month period, with the FTSE 250 and the FTSE Small Cap appearing towards the bottom of the list. The MSCI Emerging Markets index was the best performer but it still made a loss, dropping 2.12 per cent.
Performance of indices in Q1 2018
Source: FE Analytics
Duncan Lamont, head of research and analytics at Schroders, said the recent market moves should give investors a prompt to “spring clean” their portfolios and a good starting point would be to consider valuations.
“Valuations can be a very useful tool when thinking about long-term investment strategy. They are next to useless at predicting short-term market movements but for the medium to longer term investor they are an essential part of the toolkit,” he said.
“To continue the spring clean metaphor, redecorating your house to be constantly ‘on trend’ is an expensive and time-consuming task. Trends are so fickle that you may get it wrong anyway. But valuations are like investing in classic design. The outcome may not always be flavour of the month but it is likely have a longer shelf-life than the latest fad.”
Lamont said investors who have been hit with losses in the opening quarter of the year can take some comfort from the fact that valuations are now looking less extended than they did at the start of the year.
“This suggests a more favourable environment for the long-term investor,” he added. “However, we’re not out of the woods yet. Most markets, especially the dominant US (which is over 50 per cent of major global equity benchmarks), continue to be expensively valued in at least some respects.”
Schroders has researched a number of valuation indicators – cyclically-adjusted price-to-earnings multiple (CAPE), forward price-to-earnings (PE), trailing PE, price-to-book (PB) and dividend yield – and compared them with the 15-year average across five different regional equity markets.
The table below shows the results of this. Figures shaded dark red are more than 10 per cent expensive compared with their 15-year average and dark green are more than 10 per cent cheaper, with paler shades for those in between.
Valuations of major regional equity markets
Source: Schroders, Thomson Reuters DataStream, MSCI, Robert Shiller. Data covers 15 years to 31 Mar 2018
All the dark red next to the US suggests that this part of the world continues to look expensive even after some of the froth was blown off the market more recently. It is important to note that positive economic momentum and fiscal stimulus could continue to support US returns in the near term, Lamont said.
European equities, on the other hand, appear to be fairly valued as they are not especially cheap nor expensive on any valuation indicator, aside from a CAPE ratio that looks on the high side. However, Lamont noted that European CAPE is in line with its 20-year or longer average so is “not unduly concerning”; when valuations are considered alongside Europe’s robust growth story, he said the market continues to have some appeal.
“The UK is a mixed bag,” he continued. “Share prices look on the slightly expensive side, though not excessively so, when compared to earnings but cheap compared to book value or dividends. The UK’s high dividend yield has always been part of its appeal to some investors. Income of more than 4 per cent clearly has its attractions in a low-yielding world.”
However, he added a “note of caution” over UK dividends and pointed out UK-listed companies seem to be struggling to afford their payouts. UK businesses have been forced to pay out over two-thirds of their recent earnings to maintain dividends, which a much higher proportion than normal, and means investors should not be “an indiscriminate buyer” of the UK.
When it comes to emerging market equities, Lamont said they continue to look reasonably valued when compared with the developed world. That said, their strong performance has pushed prices up and the investment case is weaker than it once was.
The head of research and analytics described Japanese equities as “the most obvious buy from a valuation perspective”, given three of the four measures are in the dark green bracket and only one (CAPE) is moderately expensive. Investors need to keep in mind that Japan has an export-orientated issue that could suffer in the event of a global trade war.
“So what would my valuation-based spring clean look like? It would suggest reallocating away from the US, in favour of emerging markets, Japan and Europe. If income is a priority then selective buying of the UK could also make sense,” Lamont concluded.
“However, none of these are without risk. Markets that are cheaper are so for a reason. In these instances, maintaining a diversified exposure rather than betting it all on that daring new wallpaper you’ve been eyeing up should allow you to sleep more easily at night.”