It has been undeniably good to be an investor in equities since the trough of the market in 2008, with the MSCI World Index rising by over 100% since then. The fall in 2011 feels like a long time ago, volatility remains subdued and there is a feeling of a one-way bet forming in market behaviour.
But we have seen this before. In 1995, the five-year recovery in equity prices from the lows posted in 1990 was also impressive, as was the recovery into 2007 from the lows touched in 2002. However, you don’t need to be a scholar of the market to know the outcome of these two periods was slightly different.
The next leg for equity markets remains frustratingly difficult to forecast. Are we at the beginning of a multi-year bull run based to a degree on the largesse of the world’s central banks and their ultra loose economic policy, or is now the time to strap in for a very bumpy ride?
One thing is certain – the impact of macro news continues to be highly price-sensitive. The influence of fundamental data on individual stocks, while in no way negligible, can be drowned out by these occurrences.
The disruption caused by the Italian election results, and more recently the Cypriot banking crisis, has been a salutary reminder of the type of market we remain in. Correlations between regional markets remain high, with opportunities for diversification within global equity funds little more than illusory. The hunt for uncorrelated returns isn’t getting any easier, but that does not mean we should give it up.
Nobody wants to win the ‘least ugly’ contest, but that may be where we are with equities, that they are benefiting from being somewhat more interesting than other investment opportunities.
Many sovereign bonds currently trade on a duration that gives a feeling of bond returns with equity risk, not a top-notch situation. The dividend yield on European equities recently passed above the corporate bond yield, suggesting equities are cheap (or corporates expensive, you decide).
Stripping back equity market returns to their most simplistic assumptions can be quite informative. As we all know, equity prices are driven by a price/earnings multiple and earnings per share assumptions. P/E multiples for global equities, at 12.5 times, currently stand at levels in line with the average over the past five years. On a 20-year view, they currently trade slightly below the 14.5 times average, even when removing the insanity around 2000. There remains room for further multiple expansion, although arguably not a lot.
Earnings, on the other hand, have had a very good run. Margins remain high relative to historic norms, in no small part due to the lack of pricing power held by labour in the current economic cycle. Looking at the US market, aggregate earnings per share have doubled since the cyclical low posted in 2008. This does add up to at least a measure of uncertainty as to the likely continued expansion of earnings without a commensurate increase in revenues.
The risks outlined above are essentially beta risks. These are good risks when the market is rising, as it has been, but this is an age of astonishment, an age in which completely unpredictable events in obscure places can ambush the mightiest, most liquid equity markets – the political intricacies of deposit insurance in Cyprus can wag the entire dog of global equity markets.
In such an age, fundamentals are contingent and trends are unreliable indicators. The solution – one solution – is to cover beta risks with alpha risks, either through absolute return or market neutral, or both.
