Is grossly overrated

  • Stock markets keep making new highs. The P / E ratios in many countries are sometimes well above the historical average.

  • The reasons for the high valuations are the positive economic expectations and the low interest rate environment.

  • However, a look at the risk premium still makes stocks appear attractive.

The share prices in numerous countries have reached new highs again and again in the past few weeks. In historical comparison, absolute valuations of the shares are at the upper end due to the price rally. At the end of last year, the price / earnings ratio (P / E), a popular benchmark for assessing the markets, was 20 for the German DAX® share index, which is well above the historical average. The "Shiller KGV", a further development by Nobel Prize winner Robert J. Shiller for the American market, is currently even at 33. Only in 1929 and 2000 - shortly before major course corrections - was it higher than it is today. This spoils the joy of investors and arouses fears of an overvaluation on the stock market. But are these worries justified?

Above-average P / E ratios

P / E ratios derived from expected corporate earnings, historical averages for the period 2005 to 2020

Source: Bloomberg

In principle, equity valuations can be assessed in absolute terms, but also relative to other asset classes such as bonds. The consideration of the P / E ratio aims at the absolute valuation of the markets in a historical context. With this key figure, current share prices are set in relation to the expected corporate profits. An above-average value is synonymous with a higher stock valuation. At the moment, both developed and emerging markets have P / E ratios, some of which are well above the historical average (see chart above). Looking at the absolute P / E ratios in isolation makes stocks appear expensive.

 

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Positive economic outlook

However, there are good reasons for the high absolute ratings. The world economy is in the early stages of a possible economic upswing. The rapid recovery of the economy in the third quarter of 2020 has shown that the rescue measures of the fiscal policy are fulfilling their purpose and that a quick recovery of the economy will be possible even after the end of the second corona-related lockdown. In addition, the development of a corona vaccine, the election of Joe Biden as American president and the end of the Brexit drama have all contributed to a significant reduction in the downside political and economic risks. That should fuel corporate investment and household consumption.

There is a lot of catching up to do: US households alone have accumulated additional savings of 1.4 trillion US dollars in the past year, also due to the high level of government transfer payments. All of this should contribute to a significant recovery in corporate profits and accordingly fuel the markets.

Stocks seem expensive today, but not overvalued.

Stocks are supported by low interest rates

Another key factor behind the high valuations of stocks is the persistently low level of interest rates. Because low interest rates can have a positive effect on stocks through several channels: First, they enable companies to get cheap capital very easily. This makes it easier to implement growth projects and reduces refinancing costs. Both help corporate profits. Second, low interest rates increase the present value of all future cash flows, such as profits and dividends - and thus the value of stocks. Third, the interest rate environment plays an important role in the relative valuation of stock markets. For example, low yields on the bond market directly increase the relative attractiveness of stocks compared to bonds. The relationship between stocks and bonds is mapped using the equity risk premium. It records the mark-up on a risk-free interest rate that investors receive to take on the equity risk.

Shares still attractive

Equity risk premium and historical average

Source: Société Générale Research, January 29, 2021

In terms of the risk premium, most stocks are still attractively valued compared to their history. At the end of January, the equity risk premium in Germany was 7.2 percent, well above the average level of 3.4 percent. The picture is similar for other industrialized countries. In the USA the risk premium was 5.1 percent (ø 4.0 percent), in Japan 4.2 percent (ø 2.9 percent) and in the United Kingdom 6.3 percent (ø 5.6 percent). The main reason is the low interest rates made by the central banks, which fell sharply again in the wake of the Corona crisis due to the expansion of bond purchases.

 

Multi asset portrait

 

In the emerging markets, however, the situation is different. Here the risk premiums were below the historical average, also because fixed-income investments promised higher returns than in the industrialized countries. Chinese stocks in particular look expensive even when viewed in relative terms. The risk premium was 5.2 percent at the end of the month and was thus far from the historical average of 9.3 percent. However, historical and current data are only partially comparable in China, as the capital market has only been opened to foreign investors in recent years. Since then, a constant decline in the risk premium towards the levels of the industrialized countries has been observed.

Flexibility remains important

The stock markets have left the corona crisis behind. There are good reasons for this: on the one hand, the economy should recover quickly after the current lockdown, on the other hand, short-term interest rates in particular will remain low for the time being. In order not to jeopardize the economic upturn and the sustainability of national debt, the central banks will maintain their ultra-expansionary monetary policy this year as well and lower interest rates through bond purchases. If no further risks materialize, such as ineffectiveness of the vaccines or a lack of willingness to vaccinate, there is no fundamental basis that could trigger a sustained correction of the prices. With that in mind, stocks seem expensive today, but not overvalued. However, this does not mean that there cannot be any price fluctuations or that individual sectors are valued too high. Because the corona pandemic still has the potential to lead to strong market movements. Investors should therefore continue to value a flexible and globally diversified investment strategy in order to be able to take advantage of the opportunities that arise in an efficient and risk-controlled manner.

 

This article first appeared on February 11, 2021 in the Börsen-Zeitung (p. 13).