Charts of the Month

CHART 1 – ARE STOCKS PRICED FOR PERFECTION?

The US stock market has performed very strongly since it bottomed in late 2022, raising concerns it is now becoming overvalued.

So is all the good news priced in?

The chart below shows the S&P 500’s cyclically-adjusted price/earnings (CAPE) ratio going all the way back to the start of the 20^th century.

The CAPE ratio, otherwise known as the “Shiller P/E,” is regarded as a reliable gauge of valuation. It smooths out earnings trends over a decade, reducing the noise associated with the business cycle and other short-term factors.

Historically it has helped to signal extremes in over and undervaluation. Notably the bull market peaks in 1929 and 1999. And the secular bear market low in the early 1990s.

Typically, whenever the ratio trends above 30x (like it is now), it suggests US stocks are becoming richly valued.

That’s the bad news and reason for caution, particularly given how dominant US stocks have been in driving equity returns over the past few years.

The good news is the CAPE ratio, like most valuation metrics, is a lousy timing tool. Simply put, the US stock market is prone to staying in overvalued territory for prolonged periods, especially in the post-2008 crisis era, which has seen Central Bank liquidity support distort prior valuation “rules”.

In conclusion, investors should not ignore the fact US equities appear overvalued, but that doesn’t mean the end of the bull market is imminent.

CHART 2 – VALUE BEYOND THE US

Most valuation metrics suggest US equities are overvalued, but that isn’t the case for most other regional stock markets.

Book value represents a company’s net asset value (its assets minus its liabilities) as reported on the balance sheet. For headline indices, the book value is an aggregate measure for all constituent listings.

The blue line in the chart below shows the S&P 500 trading above 5x on a price-to-book basis. This is high, even for a growth-oriented index, and shows investors are currently willing to pay an unusually high premium compared to the value of the underlying companies.

In turn, this suggests there is little margin for error if the fundamental outlook for US companies sours.

Conversely, valuations look far more supportive for emerging market (EM) stocks, which are currently trading on 2x price/book.

As the chart below shows, with the exception of the late 2000s it is perfectly normal for EM equities to trade at cheaper valuations compared to US stocks.

However, the gap between the two has widened significantly in recent years and this will likely correct at some stage. This all adds weight to the argument we could be on the verge of a spell of outperformance for EM stocks. This will likely be led by Chinese equities, given the PBOC’s recent stimulus U-turn.

CHART 3 – CHINA’S TURNING POINT?

In recent years, mainland Chinese equities have become some of the cheapest around due to a variety of factors including weak economic growth, US/China trade tensions and outflows from international investors spooked by mounting political risks.

This has led to a significant compression in valuation multiples like those shown in the chart below with both the headline price/book (blue line) and price/sales (red line) ratios now trading around multi-decade lows.

Historically, Chinese equities have not stayed at such depressed multiples for extended periods, although some sort of catalyst is typically needed to trigger a re-rating.

We believe that catalyst arrived in late September when the Central Bank announced a raft of liquidity measures aimed at reviving the economy and the domestic stock market.

It remains early days, but it looks increasingly likely that Chinese stocks are in the foothills of a substantial “stimulus rally” that sees investor sentiment and share prices rebound on a more sustained basis.

CHART 4 – CREDIT MARKETS LOOK MORE EXPENSIVE THAN EQUITIES

Like most risk assets, corporate bond markets have performed well this year. At the time of writing, the iBoxx USD High Yield index is up around 8% in dollar terms (source: Bloomberg).

The primary drivers of corporate bond returns are interest rate (duration) risk and the credit spread. The latter represents the additional yield an investor demands over an equivalent-dated government bond to compensate for the possibility of the corporate borrower defaulting.

The duration risk is determined by how the underlying government bond yields are faring.

After their recent ascent, longer-dated Treasury yields are now trading slightly higher for the year-to-date, leaving their total return around flat. This means duration risk has made a negligible contribution to the broader credit market gains.

Which leaves tightening credit spreads as the principal driver of that 8% total return.

Aggregate high-yield credit spreads have fallen from almost 4% at the start of the year to just below 3% now, suggesting investors are becoming less concerned about default risk.

Even the riskiest parts of credit markets have seen spreads compress, despite slowing economic growth and pockets of corporate distress. The chart below shows the yield premium for issues rated CCC or lower has fallen from 10% to less than 8% this year.

Given the supportive policy backdrop, the risk of a major credit event appears relatively low, but these historically low spreads indicate a high degree of investor complacency and we believe there may be a better entry point for buying longer-dated, lower quality credit issues.