Feature – Equities
earnings from previous years, would struggle to capture such a dramatic change.
Long-term investors are now left to grapple with the puzzling effect of dramatic price movements on their portfolio. By mid- August, the S&P500 was trading above 3,300 basis points, compared to 2,300 months earlier, which could mean that the value of their investments suddenly increased by millions of dollars, even if they held the same portfolio as they did four months ago.
This could be a good reason to try and grapple with the driv- ers of absolute movements, the market beta, rather than focussing on relative price movements. The most common explanation for the recent rally in risky assets is that stock markets look beyond weaker business figures and economic data to position themselves for sunnier days in the future. Current stock market valuations could, therefore, reflect an expectation that the effects of Covid-19 will reside and company revenues and profits will stabilise. There are indeed some indications that the sell-offs earlier in the year might have been excessive and that firms were trad- ing below their intrinsic value. But identifying this intrinsic value remains a challenge.
Equity investors continue to work with indicators such as the Shiller PE Index but are faced with the challenge that the sit- uation of stock markets 12 months ago offers even less insight into a company’s current financial health than a forecast for their future does. “When we try to predict the future for the coming months or even years, we have to take into account that this is a com- pletely different situation compared to previous downturns,” one asset manager said. “Many businesses are now confronted with a situation where they book either no, or significantly less profits than they have ever had before.” Shell, for exam- ple, has cut its dividends for the first time since the Second World War, leaving investors with a return of $0.16 per share, compared to $0.47 during the previous quarter.
Fundamental challenges
Changes to the market structure have made fundamental val- uation of share prices more difficult.
Indicators such as PE ratios would have allowed the impres- sion that share prices in April offered fair value, given that prices have been adjusted, but earnings had not yet been reduced. Even cyclically-adjusted returns, as the Shiller PE index offers, do not help if the market environment is histori- cally unique. Another challenge for fundamental approaches to stock mar- ket valuation is the fact that discounted cash-flow models make little sense in a low-interest environment. “The textbook idea is that the expected cash-flows of a company can be dis-
46 | portfolio institutional September 2020 | issue 96
counted until infinity, but if interest rates are currently below 1%, it means that next year’s €100 dividend will be worth €101 this year, so the model simply doesn’t work,” says Christiaan Kraan, managing director of business development at Seeyond.
One way to circumvent this challenge is to focus on the histor- ical risk of a stock because past levels of volatility tend to be a more reliable indicator than future return expectations. Stocks which have been less volatile in the past tend to be less vola- tile in the future.
Another approach is to consider relative valuations. Com- pared to returns on 10-year US treasuries, it could be argued that the S&P500 is still relatively attractively priced. Nevertheless, current levels of uncertainty are extremely high and investors appear to respond with a reluctance to take on long-term positions. Markets have responded to a lack of medium-term visibility by shortening their investment horizon, one commentator believes. That explains the focus on immediate economic recovery and the comeback of cyclical stocks, but also the extreme fragility of stock markets. One potential indicator for longer-term investment returns could be to combine the cyclically-adjusted CAPE index with economic forecasts. One asset manager that is pursuing this approach, gives a rather pessimistic outlook. The firm pre- dicts that average S&P500 returns will be 4% to 6% over the next 10 years, giving a range from -2% to 8%.
As long as the music is playing, you’ve got to get up and dance. We’re still dancing.
Former Citigroup chief executive Chuck Prince
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