When headlines strike

Peruse any financial publication and you are likely to find some heart-stopping headlines. This is because headlines sell newspapers. The headline of the article below reads: ‘Global equities sink as uncertainty in Italy inflames fears’ – and is enough to

Given that there are currently many reasons to be negative about the state of the global economy, it is no wonder that most headlines are so negative. Investors from the developed markets, particularly Europe where the news is the worst, have all but abandoned equities in favour of perceived lower risk asset classes such as cash and government bonds. The cartoon below depicts the logic behind this trend that all the issues the world currently faces will be negative for global growth.

The reality is that although global growth may be slower, corporate profitability and equity returns may not necessarily be lower over a reasonable investment horizon of five to seven years.

Consider China as the poster child in this regard. The country has experienced one of the greatest economic booms in history over the past 15 years, with GDP growth clocking in at a mouth-watering 10.4% per annum, compared to the poor old US with its rather lacklustre 2.6% per year. Yet, with all that economic growth, company earnings growth has actually been marginally negative, while in the US it is been a healthy 5.4% per year. Similarly, Chinese equity market returns have been -2.3% per annum compared to the +6.1% per year in the US. This is certainly not a result that many would have expected and surely most of us, if offered the opportunity to invest in an economy growing at 10% per annum, would chose to do so over an economy growing at less than 3%.

(Click on image to enlarge)

Source: Goldman Sachs, 1995-2010

So why the discrepancy between economic growth, corporate profitability and stock market returns? The primary reason is that of valuation. When the outlook is rosy, investors are generally prepared to pay much more for their investments than they are when the outlook is dire. The consequence of this is that they tend to overpay in good times – so much so that even if the good times continue, returns can be poor because the price you paid was too high. Investors also tend to shy away when prices are low and offer healthy prospective returns, because the outlook is often dire at that point. The lesson here is that valuation (not news flow or economic growth) is the most important driver of investment returns over a full market cycle.

The importance of valuation is highlighted in the chart below, which analyses the returns of the South African stock market compared to the valuation of the market (from 1960-2011). The chart plots the relationship between starting valuation (as described by the price earnings multiple of the market - a number which is known at the time of investment) and the subsequent seven-year annualised return of the market.

Source: Nedgroup Investments, data from 1960-2011

Each grey dot represents a data point and the salient points to glean from the chart include the following:

• There is a noticeable pattern between starting valuation and subsequent return; the higher the starting valuation, the lower – on average - the subsequent return. In fact, the so-called ‘fit’ between the two variables is quite high at 64%. Statistically this implies that 64% of the seven-year market return has historically been attributed to the starting valuation. In other words valuation is a useful starting point for making investment decisions.
• There is clearly a fairly wide range around the best fit (diagonal) line, which implies that valuation is not a perfect predictor of returns, but rather a useful starting point when thinking about prospective return.
• The long-term average reading is represented by the blue square (which falls on the best fit line). In other words, the average PE of the market from 1960-2011 has been 11.5 times the earnings and the average annualised return has been 18%. Given that inflation has averaged 10% per year, the market has delivered 8% real growth over the past 50-odd years.
• The current multiple of the market (red circle) is around 13 times earnings. Note that because profit margins are currently at somewhat elevated levels it may be prudent to compensate for this by adjusting the multiple upward a little (let’s say 14 or 15 times earnings – marked by the green triangle).
• All of this implies that a simplistic expectation for equity returns over the next seven years should perhaps be in the region of 3-4% per annum less than the historical real return of inflation at + 8%. This would leave investors with returns in the region of 4-5% above inflation over the next seven years.

Amid all the fear and uncertainty across the globe, equities are unfortunately not screamingly cheap by any standard, but they do offer the prospect of reasonable rather than exciting returns above inflation along with a potentially bumpy ride. Equities would need to be cheaper still in order to provide sufficient upside to go ‘all-in’. That said, the alternatives may well be worse with real bond yields close to zero (or even negative) in most countries and cash yields at historic lows; both offering little protection from current inflation - and potentially higher inflation down the road.