Are the global equity markets overvalued? Given an eight-year bull run where equity valuations have more than doubled, one could argue that markets are… pick the colloquialism of choice; frothy, extended, in a bubble, in correction territory.
While I understand heightened levels of anxiety given the 2000 tech bubble and 2008 financial crisis, one should be cautious about establishing a line in the sand drawn from a period following a major market meltdown. While it is true equity markets have more than doubled since the financial crisis, valuations on a longer-term basis do not look nearly as fearsome. For example, the Dow Jones Industrial average is currently at 21,100 – give or take a few points. Since 1999, when the Dow crossed 10,000 for the first time. This represents a 4.69% annual return over that the last seventeen years. Hardly irrational exuberance!
And what about sentiment? Bull markets typically end when investors are euphoric. Believing that stocks have no where to go but up. When stocks rally after less than favorable earnings results, you want to worry. When you are offered investing advice from a taxi or Uber driver you might want to hedge your bets. But, in this environment, I see none of that. If anything, just the opposite.
Investors are worried as stocks continue to climb a wall of worry. Companies are punished for missing their quarter and rise within normal standard deviations when earnings top expectations. That tells us a couple of things; 1) analysts seem to have a good handle on current trends and 2) investors are guarded about making decisions based on short term data.
After a generation of sub-par returns and regulation overkill, valuations are moving higher, albeit at a measured pace. Expectations about the pace of economic growth remain sanguine and fiscal stimulus, tax cuts and de-regulation while on the horizon, do not seem to be driving sentiment. None of this is what you would expect to see at a market top.
But that’s sentiment which is, by definition, fickle. The real worry is when investors make decisions in a vacuum. On the surface one could argue that, price to earnings, price to book or price to sales are well above average levels. But without having a baseline on which to compare, such analysis only tells half the story.
To accurately reflect valuation, one must examine fundamentals on a relative basis against competing assets. For example, how do current price to earnings or more appropriately its’ reciprocal, the earnings yield, measure up against interest rates on ten-year US government treasuries. We cite ten-year US government treasuries because that’s one of the baselines institutional investors use to allocate capital between fixed income and equity assets.
To add a bit of meat to that skeleton, it’s important to understand that institutional investors which represent 70% of the current market value, hold a mix of equity and fixed income assets. The choice of where to deploy new money reflects the potential return and risk of one asset class versus the other. Managers allocate new capital based of the yield they can get on equities (i.e. earnings yield) versus fixed income assets (i.e. current interest rates) adjusted for risk. Risk adjustment reflects the fact that equities are more volatile than fixed income assets. The idea is to buy equities when the earnings yield provides a positive risk adjusted return relative to the yield on ten-year treasuries.
One caveat is that the earnings as defined represents historical numbers. There can be major differences between the historical earnings yield which is calculated ex-ante based on numbers from the preceding four quarters versus the forward earnings yield which is based on expectations for earnings over the ensuing four quarters. If you think that US GDP will grow at 2% per annum, which is the baseline consensus number, that would cause earnings to grow at some multiple of that based on historical precedence. Forward earnings are a key driver professional investors use to assess equity risk versus fixed income potential. But that’s a story for another day.
Keeping with the interest rate baseline theme you can see how it is used in virtually every financial decision we make. For example, if one were to look at the median value of property in the city of Toronto, you could argue that we are in a bubble. According, to statistics from the Toronto Real Estate Board, the median price for residential real estate in Toronto – including condos, townhouses, semis and detached homes – is just shy of $750,000. In 1990, the median price was around $450,000, which was just before the market crashed
Historically, the cost of a five-year fixed rate mortgage in 1990 was 12.01%. Today that same mortgage can be had for about 3.25% (depending on the credit quality of the borrower). If we are to compare apples to apples, the interest cost of carrying the average Toronto property in 1990 was about $4,500 per month, versus about $2,000 per month to carry the same property at todays price. In that sense, the housing market does not seem nearly as inflated as it was in 1990.
How much interest we pay to purchase an automobile or any large ticket item follows along the same lines. In short, interest is the anchor on the end of a teeter-totter sitting opposite the price of the asset we are considering for purchase.
So much for the metrics that support how investment assets are valued. Armed with that basic data, we need to turn our attention to the fundamentals in today’s economic landscape and compare these to fundamentals that existed prior to the tech bubble and the financial crisis.
The tech and financial crisis were both preceded by flaws in the economy. Tech stocks were fetching valuations that were not supported by earnings. In some cases, tech companies were purchased based on forward earnings more than a generation away. In its purest sense, it was euphoria supported by greed.
The financial crisis was a real estate debacle fueled by dishonesty and Wall street manipulation. Both of which have been muted by a more stringent regulatory environment. And while you could argue that President Trump is seeking to hone in regulation, any changes would require Congressional and Senate approval which at present, requires a 60% majority. The Republicans do not exert that much control in either house.
What you want to focus on are the positive initiatives being promoted by President Trump. Lower corporate taxes and massive infrastructure spending, both of which have a good chance of passing. As mentioned, I don’t think either of these scenarios have been underpinning the current move in equity prices. I believe current valuations have more to do with the earnings trajectory – yes… we have real earnings – and the fact government will be more supportive of business.
In fact, I think that the major anchor weighing on business is the potential for a border tax. My guess is that the border tax may never come to pass, and if it does, will be less punitive than a worst-case scenario. More likely this is a bargaining chip, sort of an opening salvo in renegotiating trade deals, right out of Trump’s book; The Art of The Deal.
Another consideration is higher interest rates. No one doubts that rates will rise. But it really comes down to the number of rate hikes and the degree of each hike. If we get three rounds of 25 basis point hikes in 2017 – that’s the current consensus – we end up with a 1% Fed overnight rate and long term mortgage rates around 4.5%. Neither of these should have much of an impact on GDP growth if, at the same time, wages are rising and unemployment remains below 5%.
In terms of the unemployment rate there has been much talk about the number of individuals who have left the labor force because they could not find gainful employment. They simply gave up looking which tends to skew the employment data. However, I would argue that most of those leaving the labor force are retiring baby boomers. That’s very different from someone who cannot find a job because retirees receive income from their pensions and continue to contribute to economic growth.
Another consideration is credit which remains vibrant. That’s key to economic growth. US banks have been reluctant to loan given the credit quality of the borrowers. But over the last eight years that’s improved significantly as Americans de-leverage. If we get a friendly lending environment – i.e. less regulation – that too will spur activity. Again, not necessary to support higher prices, but if it comes to pass, the so-called Trump rally may be only the beginning.
With all that said we will have a correction at some point. I think there is a 100% chance we will have a 5% correction in 2017. But that’s normal and does not by itself, imply a change in the long-term trend in equity valuations. In fact, a 5% correction historically occurs about once a year no matter the trend in the market which is why every investor should develop portfolio strategies that temper downturns.
The Portfolio Approach
Having laid out a thesis that markets are not overvalued does not imply one should hold a portfolio of 100% equities. A portfolio must include a balance of equity and fixed income assets where the weighting applied to each asset class reflects the objectives and risk tolerance of the investor. The challenge in my mind is holding fixed income assets in an environment where interest rates are expected to rise.
When you think about bonds understand that the price of the bond floats while the interest rate remains fixed. When rates rise, the value of the bond declines and the longer the term to maturity the greater the impact that has on the price of the bond. From my perspective, bonds may well be the highest risk asset within a portfolio. One way around this is to look for bond alternatives such as preferred shares and good quality real estate investment trusts.
I am suggesting good quality preferred shares as a fixed income substitute because I believe they are undervalued relative to bonds. Prior to the financial crisis good quality preferred shares (rated P1 or P2) typically traded at a yield that was 80% of the yield on the same company’s ten year corporate bonds. The yield differential reflected the tax advantages of earning dividend income versus interest income. In short, the after-tax yield in a non-registered account from a preferred share was slightly higher than the after- tax yield on the company’s corporate bonds. And prior to the financial crisis most market participants believed that good quality preferred shares were not that much riskier than the bonds on the same company.
The financial crisis changed all that. Many good quality US preferred shares stopped paying dividends because management could do so without fear of plunging their company into bankruptcy. While the interest payments on bonds are mandated through the bond’s indenture no such protection exists for preferred shareholders. Unfortunately, many Canadian preferred shares got painted with the same brush though most continued to pay dividends throughout the financial crisis. The result, Canadian preferred shares are currently yielding about 120% of the yield payable on the company’s ten year corporate bonds. That change in valuation makes these instruments an excellent alternative to bonds.
If you want further protection, consider buying so-called reset preferred shares where the dividend is adjusted based on either the prime rate or the current rate payable on government bonds. With interest rates expected to rise, these preferred share payouts will increase which will support their price. One security you might consider is the iShares Canadian Preferred Share Index ETF (TMX: symbol CPD, recent price $13.90) which is over-weighted in reset preferred shares. CPD also pays a monthly distribution of 5.122 cents per share which yields 4.584%.
In terms of real estate investment trusts (REIT), I prefer to focus on quality which leads me to the RioCan REIT (TMX: REI.UN, recent price: $26.35). RioCan also pays a monthly distribution equal to 11.75 cents per share for a yield of 5.351%.
 The earnings yield is simply a reciprocal of the price to earnings metric. For example, at the end of February, the S&P 500 composite index was trading at 2364. The previous year’s earnings were $92.56 (US Dollars). If we divide the current value for the index by the earnings, we get a price to earnings multiple of 25.54. We calculate the earnings yield by dividing the price to earnings multiple (25.54) into 1. Based on that calculation, the current earnings yield on the S&P 500 index is 3.92%.