Markets were sailing along and were caught completely unawares as the Covid-19 outbreak struck. This particularly hurt pro-cyclical sectors, such as energy and industrials, as well as value stocks. The significant appreciation of the U.S. dollar helped to cushion the blow for non-U.S. investors.
Valuations are better but were cheaper in the lower points of some previous cycles. Current forward Price-to-Earnings ratios overstate valuations as earnings expectations are yet to fully adjust.
Equities look better valued on a relative basis versus bonds. Interest rates have gone even lower and this will provide support.
Market uncertainties and risks remain high for the time being. Now is not a bullish buying opportunity, but high volatility and periods of market weakness that look likely to remain with us do present scope for longer-horizon investors to top-up equity allocations in a phased way.
Markets plunge following a long bull run
Aside from some short periods of stress, equity markets had been on a seemingly endless upward march – how quickly things change! The Covid-19 outbreak has brought forth a world in which consumer spending has halted, global travel is suspended and estimates of economic growth have been slashed, now indicating deep recessions around the world. Indeed, from an economic perspective, consumer spending really was the major support to activity as business investment growth was already weak. Now, this pillar of support has fallen over. Whilst the duration of this downturn is highly uncertain and closely linked to virus treatment developments, the outbreak has triggered precipitous falls in equity markets around the world, with all the gains of 2019 wiped out in one fell swoop. Indeed, with a more-than 20% fall from its peak in 20 trading days, the S&P 500 index entered into a bear market in the shortest time in its history! Then came an increasingly concerted and co-ordinated fiscal and monetary response from around the world1, which resulted in a sharp rebound in the last week of March. Market volatility rose to levels only seen in the Global Financial Crisis in 2008-9. By the end of March, the MSCI World total return index had fallen by around 21% for the year so far. At the same time, the US dollar has strengthened significantly over March (the trade-weighted US dollar index rose by almost 5% before reversing at the end of the month), helping to soften the blow for most non-US investors.
Trade-exposed and pro-cyclical sectors suffer most
Given the nature of global lockdowns – by some estimates, a quarter of the world’s population were on lockdown by the end of March – and the fact that most leisure activities have ceased for the time-being, it was inevitable that financials, industrials, materials and consumer discretionary stocks have fared poorly in this sell-off (see table below). However, by far the worst performing sector has been energy. This is due to the halving of oil prices following the initiation of a price war between Saudi Arabia and Russia – although there has been a bit of relief on this front just recently. Meanwhile, strong outperformance (albeit still with negative returns) was seen in the healthcare and consumer staples sectors.
Value lags hugely amongst equity styles
In the recent sell-off, value has lagged substantially. compared with the MSCI World index (see chart). Other factors that drive markets – momentum, quality, growth and minimum volatility, have outperformed.
The underperformance of value is not a new phenomenon, of course, and has been a consistent feature of markets for the past decade. There are several explanations for this, but one major reason is the ongoing weakness of the financial sector, which has faced mounting regulation, low interest rates and flattening yield curves, all of which have kept profits low. In the recent sell-off, the poor performance of the financial sector was a major factor again, as was the precipitous fall in energy sector stock prices.
Putting all of this together, we can see that the sharp underperformance of cyclical and trade exposed sectors is the main explanation of the big underperformance of value, though a bit of a recovery was seen in the last week of March.
So, what are the implications of these developments for equity valuations? Are we now looking at a good opportunity to increase allocations?
Valuations have improved but not greatly
As the table below shows, most valuation measures for the MSCI World index have become cheaper, moving towards their median levels. Note that these are to the end of March and valuations are fluctuating sharply every day – the forward PE ratio was down to 14 times on April 2nd, for example.
We can also see in the next chart how rapidly this change in valuations occurred, using the example of the forward price-toearnings ratio – again down close to the 15-year average but not much lower than that.
We need to remember that these valuation changes have occurred due to price action, whilst many of the denominators in these ratios – earnings, sales, cash flow, book value – have yet to adjust to new realities fully, if at all.
We can adjust for this by looking at long-term trends. Originally created by Professor Robert Shiller, the so-called Cyclically Adjusted Price to Earnings ratio (or CAPE) uses long-term average earnings, which can then be further adjusted for the way that earnings can naturally fluctuate at different points of an economic cycle.
The chart above for the US (which makes up over half of global equity indices), fell back sharply in March as would be expected and now the CAPE ratio is indicating that the market is back to valuations last seen in mid-2013.
Valuations were cheaper in past cycles
No two cycles are the same, but we can get some form of handle on where we currently stand in terms of valuations by looking at past downturns.
So, what did valuations look like in previous market troughs? The table below shows the averages and ranges of bear markets (using the S&P 500 index) between 1978 and 2009 for several valuation ratios (see appendix for detailed table).
Compared with the latest data as at March 31st, we can see that valuations tend to be in the range of previous bear market troughs, except the CAPE ratio. The ranges look wide but are distorted by the end of the dotcom bubble, when valuations still generally looked high because of distortions to reported corporate profits. Excluding the dotcom episode, as the table in appendix on page 7 shows, current valuations still look a little more expensive than most bear market troughs for the US. Other markets can look a bit different, but we would regard the US as the key market here. Looking at the history, these especially “cheap” periods were the Global Financial Crisis of 2008-9 and the stagflation period of 1977-78. Time will tell if these two examples will be the correct playbook for this time. We naturally think that no previous period will be exactly accurate to compare with, but we do suspect that market moves during the virus scare will be especially intense and that valuations therefore may not have quite reached their trough yet.
But how long could the current bear market last? After all, we did see an impressive rebound at the end of March. Can we really say it’s all over?
With the familiar caveat that every bear market is different and that a bear market’s length is not closely linked to the duration of a recession, a typical market downturn tends to last 12 months. This is based on the average length of bear markets since the year 1900. However, bear markets can last much longer than a year too and have done so often (see chart).
Market valuations can move around a lot and history is not always an accurate guide to what will happen this time. Our suspicion is that there will be more pain in markets before a true recovery will take hold. This comes from a view that the economic (and therefore corporate profits) impact from the virus shock will take some time to work through, and that any pronounced ‘V’ shaped recovery in output may be elusive.
Valuations relative to bonds are more supportive
In one respect, however, equities are attractively valued. As we know, very low interest rates have boosted equity markets over the past several years as investors have hunted for acceptable portfolio returns. Now, interest rates are, if anything even lower. The chart below depicts the equity risk premium for the US equity market – the excess return of equities over the risk-free rate or government bonds allowing for reasonable rates of long-term growth. At 6.7% at the end of March, the US equity risk premium is back to a level last seen in April 2013. This is an important indication of the potential relative attraction of equities going forward.
Moreover, we think that the support to equities from very low interest rates will be a consistent feature of investing for a considerable period. However, support versus bonds and interest rates typically only works if economies and profits are growing, albeit modestly. When this stops, as now, with big uncertainties on when economies and profits find their feet again, those relative attractions are not much help. So, this is a measure of support down the road once recoveries are in place, rather than in the near-term.
Earnings have started to adjust but there is a lot more to go
Valuations in bear markets tend not to provide an accurate guide to market troughs and, therefore, entry points. In fact, they make more sense in hindsight. It is important to focus on the likely evolution of company earnings over the coming year – lower profits lead to lower share prices in most cases.
The latest earnings growth estimates for the MSCI World index on March 30th have begun to be revised lower and now show a small decline of close to 1% for 2020. However, we believe that there will be large further downward revisions as companies begin to report over Q2. Indeed, the latest earnings estimates from analysts for 2020 are indicating drops of closer to 30%.
Our estimates are in the same ballpark. We have modelled the likely impact of the virus outbreak on earnings growth for this year by advancing the trend in earnings revisions by 6 months – this implies that earnings growth will be around -29% by September (see chart).
This will have implications for equity market performance of course. We can see this in action by applying some scenarios of earnings growth to the implied market price level given current valuations. As the table below shows, the combination of the current forward PE ratio of 14 times and the current index level of 1780 (on April 2nd) implies a 12 month earnings growth figure for the MSCI World index of 0% - zero growth but no declines either. The highlighted index price level represents the current situation.
Indeed, if we are correct that earnings do fall by 30%, then the implied forward PE ratio of the current index level of 1780 would not be 14 times but 20 times. Equity markets can sometimes “look through” declines in earnings if investors believe that the hit to profits is temporary in nature. It is too early to be certain whether this will occur this time, but we believe that we are only now starting to see company cash flows under strain. We do not think that there will be a rapid recovery in corporate earnings in this crisis.
Rate of share buybacks likely to fall significantly
One important way in which markets might stay in a bear market rather than rebound quickly is a likely fall-off in buyback activity.
According to S&P Dow Jones Indices, companies spent $728.7bn on share buybacks in 2019, which was 9.6% lower than in 2018, but the latter’s $806.4bn was a record. The same report also stated that total shareholder return from buybacks and dividends was $1.214trn last year, with the top 20 issuing companies accounting for 55% of buyback expenditures in the U.S. As the chart below of the S&P 500 shows, while dividend yields have been running at just over 2% in the past few years, buyback yields have been higher at between 3% and 4% - the support to equity prices has been significant.
Meanwhile, it is true that U.S. companies are at the forefront of buyback activity, but other regions have also seen rising share buybacks. Technology companies are the biggest players in buyback activity, but financials and healthcare stocks have also been major targets for buybacks. Looking ahead, why do we think that this source of market support will decline in the future? For a start, this is because the sheer uncertainty facing firms will force many of them to concentrate on controlling day-to-day cashflows, maintaining business operations and retaining employees. There simply isn’t a roadmap for the months ahead and companies will likely focus on long-term operational stability.
Indeed, S&P now believes that first quarter buybacks will be significantly lower than the previous quarter and that it will be a similarly poor picture in the second quarter. There may be a partial mitigation from the technology sector, from where about a third of buybacks emanated in 2019. Some of these companies may be able to continue with buyback activity to some extent but the disruption to global supply chains will still be a headwind for hardware manufacturers. A further 25% of share buybacks were conducted by financial sector firms and it seems likely that this activity will stop altogether in the coming quarters.
Indeed, not only do we think that buyback activity will decline in the near-term, we also think it will be difficult for activity to reach previous levels in a hurry, even after the crisis has passed. Two reasons for this could be government restrictions on buybacks to help maintain market liquidity – we have already seen these announced in the Euro Area, for example – and the public perception of buybacks.
Time will tell, but the implication for us is that this key source of market support is unlikely to be strong or present at all this year.
Recommendations for equity investors
Pulling all the strands together, we think:
- Global equities are better valued, but the valuation adjustment is smaller once large earnings declines are factored in.
- Valuations have been lower at market troughs in earlier bear markets. No two bear markets are the same, but we suspect that the valuation adjustment may have a bit further to run, carrying the risk that the market could go lower, not necessarily imminently, but sometime over the next three to six months.
- The best valuation support for equities is relative, i.e. versus zero cash rates and ultra-low bond yields. This helps sustain markets at higher levels than would otherwise be likely, though this tends to be overshadowed by economic and profit uncertainty at times like this.
- Market support from buybacks will likely be absent in the near-term.
Bear markets and their knock-on effects are unlikely to be resolved in a month. At the very least, high periods of volatility and periods of significant market weakness still lie ahead of us. We do recognise that precisely timing the bottom of a market cycle is fraught with difficulty.
Overall, we think that a lot of uncertainty still lies ahead of us but recognise that markets have started to adjust from a valuation perspective. We think that some buying, especially from a rebalancing perspective is reasonable, even though the conditions for a true return to upwardly trending markets have not been met yet. Any buying activity should be in tranches to allow for the likely continuation of some large market moves as we look ahead over the next few weeks and months.
1 See AA View – Pandemic policy response, Fiscal is monetary now
Market data source from Factset.
The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.
Aon's Global Asset Allocation Team
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