On Monday 9 March, stock markets saw the biggest one-day fall since the financial crisis. Hundreds of billons of dollars were wiped off the value of companies.
The coronavirus had already frayed nerves and resulted in a fragile market environment. Then, over the weekend, Saudi Arabia unleashed an oil price war. The oil price plummeted over 30%, sending further shock waves through the system. US, UK and European stock markets fell by around 8%. In the space of only a few weeks, global stock markets shed between 15% and 20%.
In the short-term the experience has been incredibly painful, and may continue to be so. However, for investors with long enough time horizons, this turmoil may have thrown up a silver lining. Markets now trade on much cheaper valuation multiples. Every dollar, euro or pound invested today buys more shares than it would have done a few weeks ago.
Our table below shows how different stock markets stack up across five different valuation indicators (see the end of this article for a brief explanation of each). We also show the 15-year average (median) in brackets, for comparison purposes. Figures have been shaded dark red if they are more than 10% above their 15-year average and dark green if they are more than 10% below. Paler shades show those in between (for dividend yield, it is reversed for obvious reasons).
Past Performance is not a guide to future performance and may not be repeated.
Figures are shown on a rounded basis and have been shaded dark red if they are more than 10% expensive compared with their 15-year average (median) and dark green if more than 10% cheap, with paler shades for those in between. Source: MSCI, Refinitiv, Schroders, Robert Shiller. Data cover 15 years to 9 March 2020.
The high proportion of green entries in the table gives a good indication of the cheapness on offer. The UK and Japan appear cheap on each of the measures used. Valuations of emerging markets and Europe also err on the side of being cheap. If Europe is assessed over a longer time horizon, then it starts to look even cheaper.
The US still sticks out as being the one market where valuations are above average but, even here, the de-rating has been significant. US stocks traded on a multiple of over 23 times the previous 12 months' earnings as recently as January, but this has since fallen to around 20 times. The US also stands out as having delivered the best performance in economic and corporate terms, so its premium valuation has not been without merit.
A look at income
Most enticingly, in a world where interest rates on cash are plummeting and bonds offer little - if any - yield, dividend yields are now well above average in all five markets.
Offering a dividend yield of 5.8%, the UK seems too good to be true. That is because it is. 17% of UK dividends in 2019 came from the energy sector. BP and Shell were two of the three biggest dividend payers. After Monday’s oil price crash, they now trade on dividend yields of 10% and 11% respectively, as of 9 March 2020. This is the market’s way of telling you that those dividends are likely to be cut or eliminated entirely, at least temporarily. However, even if you were to conservatively write down the energy sector’s dividends to zero, that would still leave the UK market yielding around 4.8%.
With government bond yields converging on zero everywhere in the world, other measures of relative value for stocks versus bonds also come down overwhelmingly in favour of stocks at present. In other words, while stocks have become much cheaper in their own right, when compared to bonds, they look even cheaper.
Of course, valuations are not the end of the story. Markets are in panic mode because of the uncertainty about how the coronavirus will unfold, and what the economic impact will be. As Schroders’ Chief Investment Officer, Johanna Kyrklund, wrote on Friday 6 March: “it would be unwise, even glib, to dismiss the risks of this crisis until they can be quantified”.
Further falls cannot be discounted and “catching a falling knife” can leave you with bloody hands. However, purely from a valuation perspective, if you have a long enough time horizon, stocks are now a much more appealing proposition.
The pros and cons of stock market valuation measures
When considering stock market valuations, there are many different measures that investors can turn to. Each tells a different story. They all have their benefits and shortcomings so a rounded approach which takes into account their often-conflicting messages is the most likely to bear fruit.
A common valuation measure is the forward price-to-earnings multiple or forward P/E. We divide a stock market’s value or price by the earnings per share of all the companies over the next 12 months. A low number represents better value.
An obvious drawback of this measure is that it is based on forecasts and no one knows what companies will earn in future. Analysts try to estimate this but frequently get it wrong, largely overestimating and making shares seem cheaper than they really are.
This is perhaps an even more common measure. It works similarly to forward P/E but takes the past 12 months’ earnings instead. In contrast to the forward P/E this involves no forecasting. However, the past 12 months may also give a misleading picture.
The cyclically-adjusted price to earnings multiple is another key indicator followed by market watchers, and increasingly so in recent years. It is commonly known as CAPE for short or the Shiller P/E, in deference to the academic who first popularised it, Professor Robert Shiller.
This attempts to overcome the sensitivity that the trailing P/E has to the last 12 month’s earnings by instead comparing the price with average earnings over the past 10 years, with those profits adjusted for inflation. This smooths out short-term fluctuations in earnings.
When the Shiller P/E is high, subsequent long term returns are typically poor. One drawback is that it is a dreadful predictor of turning points in markets. The US has been expensively valued on this basis for many years but that has not been any hindrance to it becoming ever more expensive.
The price-to-book multiple compares the price with the book value or net asset value of the stock market. A high value means a company is expensive relative to the value of assets expressed in its accounts. This could be because higher growth is expected in future.
A low value suggests that the market is valuing it at little more (or possibly even less, if the number is below one) than its accounting value. This link with the underlying asset value of the business is one reason why this approach has been popular with investors most focused on valuation, known as value investors.
However, for technology companies or companies in the services sector, which have little in the way of physical assets, it is largely meaningless. Also, differences in accounting standards can lead to significant variations around the world.
The dividend yield, the income paid to investors as a percentage of the price, has been a useful tool to predict future returns. A low yield has been associated with poorer future returns.
However, while this measure still has some use, it has come unstuck over recent decades.
One reason is that “share buybacks” have become an increasingly popular means for companies to return cash to shareholders, as opposed to paying dividends (buying back shares helps push up the share price).
This trend has been most obvious in the US but has also been seen elsewhere. In addition, it fails to account for the large number of high-growth companies that either pay no dividend or a low dividend, instead preferring to re-invest surplus cash in the business to finance future growth.
A few general rules
Investors should beware the temptation to simply compare a valuation metric for one region with that of another. Differences in accounting standards and the makeup of different stock markets mean that some always trade on more expensive valuations than others.
For example, technology stocks are more expensive than some other sectors because of their relatively high growth prospects. A market with sizeable exposure to the technology sector, such as the US, will therefore trade on a more expensive valuation than somewhere like Europe. When assessing value across markets, we need to set a level playing field to overcome this issue.
One way to do this is to assess if each market is more expensive or cheaper than it has been historically.
We have done this in the table above for the valuation metrics set out above, however this information is not to be relied upon and should not be taken as a recommendation to buy/and or sell If you are unsure as to your investments speak to a financial adviser.
Finally, investors should always be mindful that past performance and historic market patterns are not a reliable guide to the future and that your money is at risk, as is this case with any investment.
 UK dividend monitor Q4 2019, Link Group
Duncan Lamont, CFA
Head of Research and Analytics
Please remember that the value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
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