A Fundamentally Justified Stock Market Recovery

After the severe setbacks in global equities over the last three years, equities have again become attractive as an asset class. Even under fairly conservative assumptions on future earnings, equities are expected to offer a long-term return of about 3% to 4% in excess of short-term bonds. This should compensate for the additional risk this more volatile asset class entails. Therefore, we recommend that investors should include an appropriate and well-diversified allocation of stocks in their portfolio, in line with their individual return target and their ability to bear risk.

The ‘New Economy’ euphoria in the late 1990s was followed by a long bear market. As it evolved, investors became increasingly pessimistic about equity investments in general. The share of equities in portfolios has fallen sharply over the past three years. Have equity markets corrected sufficiently to offer attractive long-term returns and warrant a build-up of equities?

Global equity markets have staged a strong recovery from their March lows, with the global MSCI equity index up about 25%. The S&P500 is up by about 27% and some European markets by even more, albeit after having suffered a more severe downturn. But all major equity markets are still far below their peak levels. This alone is no guarantee, however, that valuations are now fair.

The question whether long-term investors should now favour equities boils down to the issue of whether the outlook for the fundamental value drivers of equity values (earnings, interest rates, etc) suggest that sufficiently high returns can be generated over the long-term to compensate for the higher risk of the asset class. Below, we draw on various measures of the value of US and European equities to assess whether the speculative bubble of the late 1990s has been fully deflated and whether prices have reached fair value (see Box 1 for a more formal definition of fundamental value and fair prices).

As first approximations, we use a simple price earnings ratio (‘PE’) and a closely related measure for the equity risk premium to check on the valuation adjustment of equities over the past years. The PE ratio relates current equity prices to earnings of a certain period. Unfortunately there exist as many PE ratios as earnings definitions (reported, operating, pre-goodwill, post-goodwill, core, etc) and to make things even more confusing, PE ratios can be calculated for past earnings periods or for any future period. The measures will therefore differ a lot depending on what definition is used. We prefer the forward PE ratio, which is based on consensus earnings estimates over the next 12 months. Although these estimates tend to be biased to the upside due to the inherent optimism of analysts, the bias is rather stable and thus allows for fairly good comparisons over time (see Box 2 for more detail).

PEs have tumbled from their highs in 1999 and 2000 to levels well below 20. Our favoured PE ratio, using forward expected earnings, has come down from about 25 to 15 and is still below 15 in the case of Europe (chart 1); the US number has drifted back up to about 17 in June and July 2003. A decline in the PE ratio from 25 to 15 reflects a huge adjustment in value, comparable to a more than 60% upward shift of the path of corporate earnings. The adjustment in Europe has been even more dramatic than that. The European PE ratio based on earnings before goodwill (ie excluding charges for goodwill write-downs that are not cash-relevant) now stands at only about 12.5. In the US, the pre and post-goodwill measures are very similar.

However, to assess the value of equities as an asset class, one does not only want to compare the price of equities to the corporate earnings one is ‘paying for’, but also to the value of other asset classes. The standard comparison to make is to relate the value of equities to those of the lowest risk fixed income investments. A simple indicator of this relative value is the difference in the yield on stocks (ie the earnings yield or the inverse of the PE ratio) and the yield on bonds (in the latter case, we use the inflation-adjusted, real yield because higher bond yields that are simply the result of higher inflation do not raise the return to investors). If the current earnings yield predicted the return on equities correctly, its excess over real bond yields would be an accurate measure of the excess return of stocks over bonds. This difference is also termed the equity risk premium.

This measure of the risk premium on stocks has shot up over the last three years as equity prices collapsed, suggesting that equities were becoming increasingly attractive relative to bonds. Our indicator shows extreme overvaluation of stocks in the late 1990s and 2000, with a risk premium close to or even slightly below zero. The revaluation of equities during the bear market shows up as a sharp increase in the risk premium to levels above those seen in 1998, when equities fell sharply in reaction to the Russian crisis and the collapse of the LTCM hedge fund. The current level suggests attractive valuations for stocks in Europe, but less so in the US.

Both the PE ratio and the risk premium measure described above suffer from the drawback that the earnings and bond yields that are compared are those of a very short period. However, financial theory tells us that the price of an equity should reflect the entire future path of earnings or dividends, that this stock will pay to its holder, discounted back to the present. Our more complete valuation model reflects this view. It uses forecasts for the evolution of earnings over a number of different stages, as follows: in the first five years, earnings are assumed to adjust from the current level to a normal or mid-cycle level, then to grow at a country specific trend or normal growth rate before adjusting to a general global trend. We also use an assumption of the normal share of earnings that is paid out to shareholders as dividends (the dividend payout ratio).

The stream of dividends that we project is discounted using the expected path of short-term interest rates and a market specific equity risk premium. We apply similar risk premia for the major markets. The premium is assumed to be 3.4% in the US and slightly higher for Europe (3.6%), to reflect higher earnings volatility. Based on these assumptions, our model shows the US equity market to be slightly overvalued, with prices about 5% above their fair value (see Chart 3). In Europe, the model still indicates cheap valuations with current prices in the Eurozone about 10% and the UK more than 15% below fair value. The world equity market as a whole is indicated to be about fairly valued, after having hit very cheap valuations in March of this year.

Asset prices can deviate a lot and for long from fundamental value, as illustrated by the New Economy equity bubble. Price movements depend on key economic and financial indicators, which drive investor expectations and sentiment. The initial recovery in equity markets in March of this year was the result of the unfolding resolution of the conflict in Iraq. The continued strength in equities, despite renewed concerns over global deflation, was then driven by improvements in corporate earnings. Cheaper corporate financing due to a sharp fall in corporate bond yields has also helped — it lowered interest costs and thus improved expected earnings — and it has reduced balance sheet stresses for many corporations.

Going forward, equity market performance will increasingly depend on a brightening economic outlook and the recovery in corporate earnings. Questions about earnings quality due to the accounting for option programmes and the impact of pension liabilities are likely to remain with us, especially in the US. But given what we think are fairly conservative assumptions on future earnings, we trust that our numbers will hold up, even against those odds. Our trend analysis and using more conservative earnings definitions than operating earnings should help to mitigate those risks. We are confident that we have seen the cyclical trough in earnings in the major markets.

Given reasonable valuations and a cyclical recovery in earnings (see Box 3), equity markets remain attractive as an asset class, also after the recent rally. This does not exclude temporary setbacks due to volatility in market sentiment, but the continued recovery in corporate earnings should provide some reassurance to investors that the prices paid are worth their money.

The fundamental value is calculated as the time and risk adjusted sum of future cash flows. Fair valuation means that the outlook for the future cash-flow to the holder of an asset promises an excess return over the risk free return (short-term bond), which compensates for the asset specific risks.

For equities cash accrues to investors via dividends. If an investor sells a stock with a capital gain, then the buyer — if rational — expects that future dividends will be worth paying the higher price. More formally, the fair price equals the time weighted sum (present value) of future dividends. Given that future dividends are uncertain, investors demand an asset specific risk premium to compensate for this risk. This additional return is called the equity risk premium and is used on top of the risk free rate to discount tomorrow’s expected dividends and to calculate what future dividends are worth today.

For bonds, the cash-flow to the investor is via coupon payments plus the nominal value at the end of maturity. Although the coupon cash-flows are fixed in advance, bond prices are also subject to risk. Firstly, due to the risk of default, which actually means that cash-flows are not risk free. Secondly, because of the uncertainty about the path of future short-term interest rates. To see this, suppose that the future path of expected short-term interest rates would shift upwards, due to a reassessment of the inflation and monetary policy outlook. This would imply that discount rates increase. But higher discounting implies a lower present value, implying a lower bond price. Even the highest quality bonds, such as US or European government bonds are subject to this risk and in cases of sharp increases in bond yields, this can lead to substantially negative returns. As a rough approximation, a 100 basis points increase in the yield of a bond with an eight-year maturity leads to about an 8% reduction in the bond price. This was about the extent of the US government bond sell-off during early July 2003.