Underneath the frenzied behaviour of the Reddit army and Robinhood investors, lie some very clear reasons for the raised equity valuations that we’re seeing today.
There is no question that equities are expensively priced in absolute terms. On any number of traditional valuation metrics, US stocks look expensive; for example, the Schiller PE of US stocks (in the chart to the left) has only been higher during the dot com boom.
Furthermore, over the past 12 months we have seen evidence of exuberant market activity; despite the effective shuttering of the global economy, equity indices have soared, the IPO market is headed for its biggest-ever first quarter and retail investors have piled into markets, driving up prices and wreaking havoc with hedge funds.
But underneath the frenzied behaviour of the Reddit army and Robinhood investors, lie some very clear reasons for the raised equity valuations that we’re seeing today. Here, we will explore what those factors are, how long they could remain in play, and how we’re deploying capital as a result.
What’s driving prices so high?
The main drivers behind rising equity prices have been the high levels of liquidity, and the relative appeal of equities as interest rates have continued to fall.
While equities look expensive on an absolute basis, they still look appealing on a relative basis compared to bonds; in short if equities are expensive, bonds are even more expensive. Indeed, the fall in bond yields over the last 40 years has been the driving force upwards in equity valuations, as you can see in the chart above.
Arguably in the last year equity prices have been driven higher on the back of easy liquidity from loose monetary and fiscal policy. This year the base case is for economies to recover as health conditions ease, and economic activity and corporate profits recover.
Value vs growth
The forces that have been driving up equity prices have not done so equally; growth stocks have been the fastest to feel the pressure from rising bond yields because they have been the greatest beneficiaries of falling yields. Over the past 12 months the areas that have been hottest have been thematic sectors like software, renewable energy and clean tech which benefit from falling yields; stocks that have good enough stories behind them to help get investors over the mental hurdle of having to pay through the nose for future earnings. In the past few weeks, these sectors – and growth in general – has seen a sharp and widespread correction as yields have risen.
The forces that have been driving up equity prices have not done so equally; growth stocks have been the fastest to feel the pressure from rising bond yields because they have been the greatest beneficiaries of falling yields.
Value equities meanwhile, were weak for much of 2020 but have enjoyed a resurgence in the last 6 months; the capital that flowed out of growth and tech stocks has largely been reallocated towards value – and particularly cyclical – stocks whose earnings are geared into economic growth.
What could derail equity markets?
Some of the main risk factors for this year are those factors which could remove the support of liquidity, or lead to slower growth and higher inflation. These include tighter financial conditions from rising interest rates and a stronger US dollar, worsening health conditions, policy disappointing expectations and tightening prematurely and slowing growth in China as credit conditions cool.
Inflation is a medium term risk. The rotation that we have seen into value stocks was fuelled by rising bond yields, and the perception that the economic recovery will boost their earnings. However, if we see economic growth rapidly speed up, and demand start to outstrip supply, all while the global economy is still being pumped with vast amounts of monetary and fiscal stimulus, then there is a real risk of higher inflation.
Inflationary pressures also could make it more likely that the Fed hikes rates sooner than investors are currently positioned for. Were that to happen, we would see a major bond market selloff and would be highly likely to see a sharp selloff in longer-duration growth equities. Commodities and inflation linked bonds would help protect against the worst of the inflation, while value equities could see contagion from a wider market selloff, but would still be less vulnerable than growth stocks. The balancing factor to this risk, is that central banks have made clear that they don’t mind letting inflation run hot this year, but there is still plenty of uncertainty as to what level they would consider “too hot”.
What is our approach?
Overall, we think the base case is supportive for equities in the short term, driven by strong liquidity and a rebound in growth and corporate profits. However, we balance the risk of high valuations, through portfolio diversification, portfolio protections and dynamically controlling the level of equity exposure.
We seek to position portfolios to take advantage of the parts of the market which are most attractively priced, such as equities outside the US and value stocks, which will also benefit from an economic rebound. This is balanced with selective exposure to quality stocks and active tech exposure with high quality stock pickers in public and private markets. We make use of call options to protect portfolios against the scenario in which liquidity driven markets develop into a full-blown bubble.
Lastly, alternatives, including commodities, inflation linked bonds and other diversifying asset classes and strategies have an increasingly important role to play in the current environment. They provide a counterbalance to equity exposure without having to be reliant on bonds for diversification, while also protecting against various inflationary pressures.
All information and opinions expressed are subject to change without notice. Advice is given and services are supplied by Capital Generation Partners LLP and its affiliates (“CapGen”) on the basis of our terms and conditions of business, which are available upon request. No liability is accepted or responsibility assumed in respect of persons who are not clients of CapGen, unless expressly agreed in writing.
This does not constitute investment advice or an offer, contract or other solicitation to purchase any assets or investment solutions or a recommendation to buy or sell any particular asset, security, strategy or investment product.