Are equities really that cheap?

Absence from the office over the festive period often provides a sense of perspective about markets and the views of their participants. This writer’s return to the fray last week left him very aware of one clear consensus view. It seems that every man and his dog are positive about equities vs. bonds, credit and cash. This has been most apparent in breathless sell-side chatter, but is also reflected in positioning surveys and the strong relative performance of equity markets. But are equities really that cheap?

On the face of it, equities look very attractive based on a simple equity risk premium (ERP) approach. The current ERP for global equities is 6.75%, calculated using the difference between the forward earnings yield (the inverse of the forward PE) and a real global bond yield (this reading is a bit higher than the proprietary risk premia that derive from our analysts’ bottom-up estimates). This latest ERP of 6.75% is +1.5 standard deviations above the 21-year average of 3.8% and suggests equities are attractive vs. bonds. Indeed, according to this series, the last month that global equities were at extremes (a two standard deviation event) was August 2010, at the end of the correction that had started in April. Prior to that, the last “2-SD” event was in March 2009, when global equities reached a post financial crisis low.

Nevertheless, we are more conservative on the valuation front because we believe that markets will require a higher ERP over the next five-to-ten years. This is because households and governments in the OECD are likely to deleverage over the next decade and this trend is expected to have a detrimental effect on the level and volatility of growth and inflation. Consequently this suggests that we should compare current risk premia with a shorter-term average, which effectively acts as a proxy for the changing equilibrium. Using this approach, then the current ERP of 6.75% looks less impressive, being 0.81 standard deviations (SDs) above the ten-year average and just 0.16 SDs above the five-year average (see graphic [1] below )

An alternative valuation metric, the Shiller PE ratio (or the cyclically-adjusted PE multiple, CAPE), also suggests that equities offer limited value. US equities are currently trading on a CAPE (which uses trailing ten-year earnings) of 23.3x – well above the 140-year average of 16.4x. This compares with a CAPE of 13.3x in March 2009 and suggests that equities have become expensive again. This exercise highlights an important distinction between the equity optimists and pessimists. A positive strategic view on equities either implies a return to a pre- 2007 economic normality with an early end to deleveraging and a resurrection of the credit transmission mechanism. Or the strategic case relies on sizeable valuation premia to justify investment amid lingering economic uncertainty.

We are not convinced we have seen the end of deleveraging and thus are sceptical that equity markets are cheap.