Markets

Valuations Are Extreme. Stocks Can Still Go

Up
It all depends on earnings fulfilling rosy expectations.

By John Authers
28. Juni 2021, 06:00 MESZ

Room to go higher?
Photographer: Matt Cardy/Getty Images 

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Have We Earned It Yet, Baby?

Somehow or other, the U.S. stock market is at yet another all-time high. The S&P 500 has
risen 91.3% from its Covid panic low last March. With the year not quite half gone, it is up
14%. These are very impressive results, particularly with the latest consumer price index data
showing the worst inflation in main street prices in almost three decades.

The U.S. is also running a long way ahead of the rest of the world. The MSCI World Excluding
the U.S. index is somewhat below the high it set earlier in June. In the long run, the difference
between the two is extraordinary. It was only a couple of weeks ago that the world excluding
the U.S. topped its previous all-time high, set on the ominous date of Oct. 31, 2007. As of
Friday’s close, the index is 0.18% higher than it was on Halloween 14 years ago. I couldn’t be
bothered to get the Bloomberg terminal to calculate that as an annualized rate. Here is how
the indexes have compared since that pre-global financial crisis peak:

There are some obvious explanations for this. All the biggest winners from the growth of the
internet and online commerce have been American; the euro zone inflicted the sovereign
debt crisis on itself for much of the last decade; the Federal Reserve was far faster and more
enthusiastic to prime the pump with quantitative easing asset purchases. But still, the U.S.

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economy continues to cause great discontent amid the population at large, and it’s not as
though the rest of the world has suffered anything like the Great Depression, outside small
pockets such as Greece.
If there is a long-term driver, it is corporate earnings. The following remarkable chart comes
from Doug Ramsey of the Leuthold Group in Minneapolis:

Since that Halloween peak, there has been an astounding 90% correlation between different
countries’ growth in earnings per share and the change in the value of their stock markets (as
measured by MSCI). And, almost equally astoundingly, most developed countries have seen
earnings fall over the last 14 years. That means that the U.S. has performed much better than
the rest. The only country to come close is Denmark (powered by Novo Nordisk A/S, which
has increased sixfold since Halloween 2007). 

Overall, earnings are down outside the U.S., including developed and emerging markets. This
is the same chart I began with, but this time showing Bloomberg’s estimate of forward
earnings, rather than share prices. The two charts do look similar:
Ramsey points out that a weakening currency will make U.S. companies’ profits look even
better in dollar terms, so the dominance is unlikely to be shaken any time soon. But the
broader point remains:

We often joke about the over-optimism of earnings forecasts, but this is ridiculous. In 2021 -
with much of the world engaged in QE for a decade or longer and short-term interest rates
either at, near, or below zero — most countries are struggling to put up earnings per share
levels that analysts once deemed likely for 2008.

How to explain this? Plainly, this speaks to excruciatingly poor economic performance in
much of the world. This may not have been a depression, but growth has been slow since the
crisis. There is also an anti-American argument for the many people who want to make it.
U.S. authorities have allowed a number of internet groups to buy up their competitors and
become deeply entrenched, and they are now busily eating up profits that would once have
accrued to companies in other countries. It’s no wonder that European competition
authorities are getting aggressive about this. And there is a positive American argument: The
internet, which originated in the U.S. military-industrial complex, has allowed corporate
America to innovate and grow in a way that has eluded everyone else. 

Leaving that long-term argument to one side, the short-term implication is that even if price-
earnings ratios look extremely high (which they do, particularly in the U.S.), it is plenty
possible for share prices to rise even as multiples fall, if profits keep expanding. This chart of
global equity returns is from Ian Harnett of Absolute Strategy Research Ltd. in London. It
decomposes growth due to dividends, earnings growth, and multiple expansion. Over the last
12 months, in which equities have somehow returned 39.7%, widening P/E ratios have
accounted for most of the gain:
It is only rational to assume that valuations will come down. However, the experience of
2010-2011, highlighted in the chart, shows that it’s still possible for stock markets to gain in
these circumstances. The start of that period was a messy year filled with gloom over
currency debasement, the debt-ceiling row in the U.S., and the beginning of the euro-zone
debt crisis; but earnings still grew by enough to counterbalance the fall in multiples, and
stocks rose. A “benign compression” in valuations can happen. If we suffer a liquidity shock
or another unexpected blow from the pandemic (of which more below), then valuations
make it very hard for stocks to make more progress. But there is a possibility of growth from
here.

To end with a note of caution, however, Absolute Strategy also breaks down global equity
returns since 1975 into earnings and multiple expansion. Differences in earnings in the post-
crisis era have determined which markets have won and which have lost, but in the longer
term, multiples have been far more influential in driving returns.
The bottom line? Earnings season, three weeks away now, probably matters more for stock
prices than the rash of macro data that will start at the end of this week with ISM surveys and
U.S. non-farm payrolls. There had better not be too many negative surprises. With valuations
so high, it behooves everyone to be aware of the risks of a fall. But it also behooves those (like
me) who’ve been warning about the risks of excessive valuations to accept that there’s still a
way that markets could gain further from here, if earnings fulfill rosy expectations. 

Cautionary Tale From Home

The most dangerous risks are the ones we don’t understand, or don’t see. All of us, including
plenty with medical knowledge, have learned what we don’t know about infectious diseases
and their effects on the economy over the last 18 months. So I offer the following case with
due humility. It would seriously be a good idea to keep an eye on the pandemic in the U.K. in
the next few weeks. This is how the trend in daily cases has moved since the beginning of the
outbreak last year:
Obviously, the rise in infections should concern everyone. To recap, the U.K. proved to be a
test experiment first on the British variant, then on being the first developed country to
execute a successful mass vaccination program, and is now the first developed country to
host an outbreak of the delta variant. A big vaccination campaign hasn’t stopped another
wave of infections and hospitalizations. So far it hasn’t led to a significant rise in deaths:

What do we need to learn in the next few weeks? The disaster scenario involves the variant
gaining further in strength, and hospitalizing and killing more people — even if they have
been fully vaccinated, as a significant proportion of current patients have been. If deaths stay
this low, and the variant doesn't inflict long-term negative consequences on patients, it could
almost be seen as good news; the vaccination campaign has saved the lives of the most
vulnerable, and the latest outbreak is most serious among younger people who are less likely
to be vaccinated, and also less likely to be in mortal danger. This could be the final stage
toward reaching “herd immunity” for the U.K.

One alarming implication of the U.K. experience, however, is that even a massive vaccination
campaign doesn’t get us to herd immunity. At one point there were optimistic projections
that only about a quarter of people needed to be infected or vaccinated. Now it looks as
though that number is much, much higher. And the longer we wait for herd immunity, the
longer the virus has a chance to develop new variants, which may prove resistant to vaccines.
As it stands, the base scenario, which many are beginning to regard as a certainty, is that the
pandemic is on its last legs. That is still a reasonable prospect. But the British experience has
already had real world economic effects. Reopening has been postponed for a month, and the
Bank of England might well have tapered its support for markets last month had it not been
for this renewed outbreak. There is no reason for terror, but every reason for investors to
keep a close eye on Covid figures, particularly for now in the U.K.

Authers Indicators

The latest update of Authers Indicators (the glorious name, which wasn’t my idea, for our
inflation heat map) is here. You need to squint to see the changes from last week, as there
haven’t been many new economic releases. In brief, market breakevens turned up a little, as
did commodity prices, to make up for the overreaction to the Federal Open Market
Committee meeting the week before. This leaves most of them plumb in the middle of their
range for the last 10 years. Among raw material prices, lumber futures are fast coming back
down to earth, as predicted and hoped by many, while the CRB RIND index, second from
right in the raw-material prices row, continues to rise. This is of interest because it covers
commodities that aren’t available on futures markets, and therefore should be a purer
representation of demand and supply pressures, and not affected by swings in sentiment
about the Fed.

The one serious extreme square is rental car inflation. It would be disconcerting if that cell
weren’t much paler blue after the next CPI data. The broad overview remains; the official
data are plainly elevated, and consumer and business surveys continue to show concern;
investors and economists are relatively unconcerned, while wage growth remains under
control. There is inflation, but everything so far is consistent with it proving to be
transitory. Keep watching this space.
 

Risks & Rewards

Lisa Abramowicz and I held our third livestreamed conversation on the markets on Friday,
and we hope that it will help you get ready for next week. Lisa started by commenting that
markets seemed to have lapsed into a post-FOMC stupor, as if nothing, even a taper, really
mattered. That led to an attempt to trademark the phrase “taper stupor.” It’s almost as good
as “taper tantrum” but slightly harder to pronounce. 

As you might guess, both of us are rather concerned about complacency, and the difficulty
people seem to be having with even imagining what might go wrong from here in markets.
There’s certainly a reasonable base case that things go well, but it’s best to remain humble,
particularly when one of the primary risks is biological, not financial or economic. You can
find the conversation here.
 

Omissions

In last week’s discussion of bond factors going back to Waterloo, based on a paper from the
quants at Robeco, I forgot to provide a link to the paper. You can find it here. My apologies for
the omission. 

Survival Tips

I still have sport on the brain, I’m afraid. As Denmark are proving one of the wonderful
stories of the European Championships, let me remind everyone of my favorite Danish export
to help me get through the pandemic, the TV series Borgen, which is still streaming on
Netflix. It’s a fantastic, twisting and turning drama about Danish politics. Imagine a rather
strange hybrid of The West Wing and The Girl with the Dragon Tattoo, and you get the idea.
Perfect binge viewing. Meanwhile, for those who had never heard of Christian Eriksen before
he became famous for suffering cardiac unrest on the field in the Euros, here are some of the
goals he scored for Spurs as he became a star.

John Authers' Points of Return

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Meanwhile, in baseball the Red Sox have just completed their second successive sweep of the
Yankees. A very welcome improvement on last year. I’ve been lucky to be in Yankee Stadium
for some great Sox moments in recent years. So, here are some home runs from Rafael
Devers in 2017, Brock Holt in 2018 (to complete the cycle), and Bobby Dalbec earlier this
month. I had a great view of all of them. May they never get old. Have a great week,
everyone. 
 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its
owners.

To contact the author of this story:

John Authers at jauthers@bloomberg.net

To contact the editor responsible for this story:

Matthew Brooker at mbrooker1@bloomberg.net

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