Valuation Comments 1-6-14
Among the major developed equity markets, US equities are the most overvalued while most European and Asian markets remain undervalued.
It is important to remember, however, that equities are financial assets, claims on future earnings potential. In addition to the outlook for their future cash flows, their value at any given time should reflect the cost of capital. A low cost of capital, whether held down artificially by central bank action or made available by exuberant bond investors, should be expected to pressure equity values higher. Today we have an unprecedented level of monetary accommodation, more expansionary than in 1999, and equity valuations are nowhere near where they were in 1999. It seems to us that there is a lot of room for significantly higher equity valuations, as investor confidence returns, before the major central banks take away their punch bowls.
A simple indicator, made popular in recent years by Alan Greenspan, is a comparison of earnings yield with long bond yields. Using 2014 estimated operating earnings for the S&P 500 gives an earnings yield of 6.6% vs 4% for 30-year Treasury bond yields (and 3% for the 10-year note). Note that earnings yields and bond yields should both average about 6% over time. This indicator gives the same result today for all the major world markets.
The recent bursting of the housing bubble and subsequent credit crisis was largely a developed market phenomenon, leaving emerging market (EM) economies relatively unscathed. Much has been written about their rapid growth rates and economic progress. Significant capital flows have come into emerging market equity and bond markets as a result since 2009. Risks were likely under-appreciated and “bubbles” may have formed. Mid-2013 was a reminder of why they remain classified as “emerging”. We may get more reminders in 2014.
We continue to hold above-normal equity positions in Europe and Japan and below normal ones in the US and Pacific (ex-Japan). Emerging market equities continue to make up a small and well-diversified portion of our equity portfolios.
Major world central bank actions continue to artificially keep government bond yields below levels consistent with inflation and growth expectations. This means all bond investors remain undercompensated and at risk of capital loss from government yield curves. Credit spreads continue to be pressured lower by gradually improving world economies and investor risk appetites. This means growing risk and falling compensation for credit investors.
Fed tapering fears last year gave a wake-up call to those invested in EM bonds, particularly the more recently popular local currency and corporate credit versions. Add up your credit risks: 1) sovereign risk, 2) currency risk, and 3) corporate credit risk. Dollar-denominated EM bonds have 1). Local currency EM bonds have 1) and 2). Corporate EM bonds have 1), 2) and 3). Those who have all three better really pay attention. Note that we have always only been comfortable with dollar-denominated EM bonds and moved to an underweight position as those spreads dropped considerably over the past few years.
Our bond portfolios are overweight US investment grade and high yield credit and underweight US Treasuries, through short and intermediate term bonds. Positions are above normal in developed market non-US bonds and below normal in EM bonds.