The price of equity markets has been a talking point for many months, with many investors concerned there could be a correction just around the corner. Yet despite recent political events, and seemingly stagnant global economic growth, equities continue to ride high.  So are they overpriced, or are they just correctly anticipating higher earnings? As with most things, it depends which way you look at it.
One way of determining the true value of equities is to look at its price relative to its own history. Currently, most equity valuation measures (such as free cash-flow yields and price-to-earnings ratios) indicate that the asset class is trading ahead of its long term trends. Of course, it could be that this is justified, but there are good reasons to suggest this is not the case.
Equity prices are a function of earnings, and the valuation multiple that the market is prepared to pay for these earnings. The performance of equities is therefore a function of how these two things change over a period of time. Currently businesses continue to be plagued with luke-warm economic growth, a high base of profit margins and declining labour productivity. Despite this, equity markets are optimistic about the future and investors are prepared to pay a premium valuation multiple today in the hope that the promise of reflation and pro-growth business policies will boost company earnings to the point where this price is justified. The concern for entering the equity market right now is that this positive outlook is already largely reflected in asset prices, and risks being derailed in the longer term if company earnings fail to deliver.
When equities are viewed relative to other asset classes, such as government bonds, the excess expected return relative to that of bonds shows that equities as an asset class are not expensive. In other words, there are lots of vehicles you can use to invest your money, and government bonds are looking expensive for the amount of potential reward you would get for your investment, suggesting that equities are a better bet. The trouble is, this view doesn’t account for the fact that, globally, Central Bank policy has been artificially holding up the price of bonds, making their valuation something of a red-herring. We don’t believe it’s a reliable marker right now, and prefer to take the valuation view.
We continue to believe that equities are pricey and warrant a cautious approach. That said, we also believe the long-term outlook for this asset class remains positive, but we would like prices to fall to more attractive levels before we became more aggressive. For example, as we progress through 2017 we expect some of the unknowns dragging on UK companies to subside, we might expect to see the mid and small-cap indices resume their trend of outperformance.  Within the UK, smaller companies sector there is a large cohort of companies trading at relatively attractive valuations which, all else being equal, provides a firm base for attractive future returns.
The question for us is one of intrinsic valuation and ensuring that we are able to take advantage of any price dislocations should they arise. Indeed, we expect there to be volatility in markets over the medium-term and therefore remain patient and vigilant, waiting for the assets that we like to trade at a price that makes sense to us.