Deep dive into equity valuations: how high are they, and where are the remaining opportunities?
Many clients worry about high equity valuations compared to history. But on aggregate, there are good reasons for equity valuations to be where they currently are. That said, volatility is possible, and it is important to differentiate within markets and sectors. Cheap can be costly, while some of the expensive winners may keep winning. Valuations are important to watch, but not the start and end of investing.
- Equity market valuations are higher than the historical average, but not at a bubble range. Fundamentally, the current high valuations are in line with our top trend for 2021 of 'Recovering in a Low Yield World': it is because of low rates, global liquidity and positive and improving growth, that high valuations are warranted.
- Unless growth or rate assumptions change, P/E ratios should not drift lower. But volatile inflation numbers and the unpredictable impact of COVID on growth may lead to some temporary volatility in P/Es, which investors may want to manage. What should provide comfort is that even if P/E ratios were to fall slightly, equity returns should still be positive, given market expectations of 20 per cent+ earnings growth this year, depending on the region.
- Concerns over valuations may principally reflect nervousness about some of the largest technology stocks. But we do not think a comparison with tech during the dot-com bubble would be fair, as most tech companies generate healthy earnings. Still, we continue to diversify from US large names into tech-related themes such as 5G, automation, health technology and the digital consumer, where we often see better value or less headline risk.
- We also note that across and within sectors, there is a large dispersion in valuations. Some companies warrant much higher valuations than others, often because they are better adapted to the digital and sustainability revolutions, have stronger balance sheets or better management. So, we see opportunities in both growth companies and also in select value stocks (where we try to avoid the value traps).
- Any analysis should weigh valuations against fundamentals. Recently, some stocks have been pushed higher by retail flows that are based on momentum rather than fundamentals. This is feeding more inflows and more positive momentum. Of course this can be dangerous, as it is very difficult to know when that momentum would stop. If stock prices become more erratic because of this new phenomenon, this could hurt equities, as it would make the risk/return relationship less attractive.
- As for EM, even after the recent sharp rally, China's equity risk premium is reasonable. Any changes to credit policy will be targeted and gradual, and we continue to overweight Chinese stocks, with many opportunities in our themes of 'Recharging Asia's Growth' and 'China's Green Revolution'.