A broader look at valuations
Valuations have been the moving part in equity markets this year. The S&P 500 price-to earnings ratio (PE) has dropped from the close to 22 times 12-month forward earnings at the end of last year to around 16 times as of the week of 19 Sep. This 25% de-rating is historically unprecedented absent an economic shock which would indicate an impending recession. Yet despite the sharp correction, the PE remains well above typical recession levels. It has broken below the 5- and 10-year averages, but remains above the 20-year average. A look at the downturns over the past 10 years also shows that it always dropped below 15x when the economy suddenly slowed and went as low as 12.2x in 2020. During the global financial crisis (GFC) in 2008, it even dropped to below 9x. What’s been different back then, is that rates had not yet embarked on their “shift towards zero”, which took hold in the low-inflation post-GFC world. The 10-year average of US real rates came down by almost 150bps between 2012 and 2022, compared with the 10 years before.
Why does this matter? The US real rate arguably is the most important discount proxy in global markets, not only for equities, but also other assets classes, such as gold. If this post-GFC era of low rates were to come to an end and inflationary pressures stay with us, central banks would need to dust off their old manuals and keep rates structurally higher for years to come. That would also mean that PEs have to be structurally lower, more in line with the 20-year average than with the 10-year average.
Yet even just looking at the past 10 years, equities still appear to be priced expensively against what the current level of real rates is suggesting. More granularly, the inflation-adjusted Fed Funds futures (3 years), which we found to be most accurate in predicting US PEs, indicates a PE of 15x, or more than 5% below current levels. The only good reason equities have been trading above the levels suggested by real rates in recent weeks is the hope that a potential drop in inflation prints would quickly remove market-implied Fed hikes. The Fed, however, is dashing these hopes right now.
While the terminal rate has not moved as much, the Fed has been adamant in making clear that a slight drop in inflation would not be sufficient to reverse course. The FOMC message has shifted from “higher” to “higher for longer”, effectively nailing down the long end of the Fed Funds futures curve. As a result, we expect equity valuations to catch up (or better: catch down) with “real Fed Funds futures”, rather than the other way round.
Other valuations metrics do not provide a much more comforting picture than the PE. The US dividend yield has closely tracked the US high-yield spread over the past 15 years, only to fall back significantly as equities surged after the pandemic stimulus had been enacted. The convergence between dividend yields and HY spreads since then has been very limited, with dividend yield levels still far too low for the current US high-yield spread.
Longer-term valuation metrics also suggest a cautious stance on equities. Equity-risk premium (ERP) has moved back below 6%, largely as a result of higher bond yields. While the ERP is a bit of an ambiguous concept and highly sensitive to assumptions made for growth, inflation and rates, the relative performance of equities to bonds tends to correlate positively with it. Lastly, the cyclically-adjusted Shiller-PE (CAPE) also remains above its 20-year average, even after the de-rating year-to-date. It has been a surprisingly accurate predictor of long-term equity performance, implying 11% annual returns over the past 10 years. After the sell-off this year, the annual return since Q3 2012 has been 12%. Over the coming 10 years, the current Shiller-PE level suggests annual returns of around 5% p.a.. While this is only an indication and far from being a certainty, it is just another reflection that valuation levels of equities are not considered overly attractive yet.
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