The very forces of gravity that keep us from floating up into the murky winter sky seem to inform our market beliefs too. As stock markets around the world march to successive all time highs, we struggle to suppress the sense that a juddering return to earth, wherever that may be, is a step closer. The idea of putting one’s hard earned money to work in an index (price or total return) that sits at all time highs is surely counterintuitive, a perversion of the time-honoured advice to ‘buy low, sell high’?
That stock markets are at the mercy of alternating cycles of extrapolative euphoria and pessimism is accurate – only recently, popular theories on a ‘new normal’ and ‘secular stagnation’ attest to this collective lack of imagination with regards to even the near future. However, as we’ve noted before, timing these mood swings is easier said than done, whilst even not attempting to do so can be less costly than imagined. The fact that ‘the ground’ – represented by corporate profits for stock markets – tends to rise over time, provides a forgiving context for investors.
As the world economy grows, so too do corporate profits. The relationship between the two is not as precise as forecasters would like, but there is no fixed limit for either. The world economy is now 38% larger than it was in 2007 (23% in per capita terms), providing a larger market place for the various companies that dominate the world’s stock market indices. In theory, in a growing economy, stock markets should be reaching all time highs every day, because corporate profits will be too.
What about valuations? Not a week passes without one commentator or other telling us how dangerously expensive stocks are – the monetary experiments of the post crisis era are perceived to have loosened gravity’s grip on equities, particularly in the US. There is much to say on this debate, but probably the most important point to reiterate for investors looking to the next 12 months and even a little beyond is that valuations are simply not a very good predictor of returns over this time frame. The last 12 months of stellar returns, amidst apparently asphyxiate valuations, pays ready testament to that fact.
It is also worth keeping in mind that we are always investing in a slightly different index as well. Close to 20% of the constituent companies of today’s S&P by market weight were not even in the index at the end of the last economic cycle. This perhaps also goes some way to illustrating the difficulties in looking to history for precise answers on valuation multiples – when does the comparison cease to be relevant due to changes in accounting standards, index composition, and wider economic context?
Valuation is, nonetheless, an important input into longer term returns. Today’s levels, although not as alarming as the caricature in our opinion, certainly suggest that we should temper our expectations for the next 10 years a little.
We are not expecting a repeat of 2017, or indeed 2016. The world economy isn’t likely to continue accelerating as it has over that period. Meanwhile central bankers and bond markets should become less accommodating. However, we do not yet see stock markets as disconnected from an increasingly vibrant economic reality. Neither do we yet see the signs of economic hubris or excess demand that herald the end of some economic cycles. This suggests that the all-time-highs being rung in by the various stock markets around the world are another staging post to be ignored. Corporate profits should continue to grow and so with them shareholder returns.
Analysts are no doubt expecting too much earnings growth – they usually do. Higher interest rates should crimp valuations a little too. However, even taking these into account, stock markets still look the best game in town, both for the short and long term. Continue to invest accordingly.