BY GUY CARSON
Markets by their nature are unpredictable but one of the strongest forces over the long term is reversion to the mean. Stocks which outperform in one period tend to underperform in future periods and markets tend to pause or retrace after periods of high gains. With this in mind, last year was one of the best in recent history. In addition, drawdowns were few and far between with the biggest fall being 7%. Again this was in line with the best years in recent history.
Of course the seeds of 2019 were planted in the last quarter of 2018 when markets sold off significantly. As we have previously written this was down to the Federal Reserve pivoting from tightening to easing. The subsequent interest rate cuts are the driving force behind the market moving higher.
We can see the impact of the Fed when we look at earnings over the last year. Earnings per share actually fell 4% in the year to the end of September. This was driven by margin compression whilst revenue rose slightly and buybacks outpaced share issuance.
Rising prices and falling earnings mean that valuations have become more expensive. On almost every measure shares are expensive. Of course, the one aspect that can justify current prices is interest rate and bond prices. As pointed out above, this is the key driver of markets over the last year.
The higher the valuation, the lower the future expected returns. As P/Es rise future returns drop. At the start of 2019, prospects look better due to the 4th quarter pullback in 2018.
However one side effect of the current world we live in is that low interest rates do justify higher valuations. This puts markets at an interesting juncture. There are two key variables in assessing valuations: earnings and discount rates. Discount rates are formed via risk free interest rates combined an equity risk premium.
If the recent softness in earnings continues then markets might struggle to hold their current levels, however if earnings growth returns then valuations could perceiving go higher. This is particularly true if the Fed continues on its current trajectory and rates continue to fall.
Looking at the overall market P/E doesn’t tell the full picture. One of the big stories under the surface of this market has been the dispersion between value and growth. This is most notably true at the smaller end of town where valuations are a long way above historic averages.
In addition, Private Equity valuations have risen to the point where research firms such as Bain & Co are pointing to a private market premium as opposed to a discount. Investors are paying more for Private Equity in order to reduce the volatility of the portfolios and driving private valuations up. Investors such as Calpers CIO Ben Meng have said they need more exposure to Private Equity and “we need it now”.
This market has faced a trade war, an impeachment, falling earnings and an inverted yield curve. Despite all this the market continues to drive higher and post new highs. Under the surface dislocations are appearing. There is one reason behind it all: the Fed. And whilst we would never recommend “fighting the Fed”, these are definitely times to be circumspect. Small cap growth stocks and Private Equity are showing signs of excess whilst more traditional value strategies are struggling. Reversion to the mean has always been a powerful force in financial markets and we expect this to hold. However, in the short term trends can last longer than expected. As a result, 2020 shapes as an interesting juncture for financial markets.