It can be unnerving when stock markets regain previous peaks, as demonstrated by the S&P500, which has hit all-time highs in 10 of the last 13 months. However, most big indices are still below pre-crisis peaks, and post-crisis performance can mostly be explained in terms of earnings, not valuations.
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Recovery of equity markets has been uneven
Figures 1and 2 show the major equity markets (MSCI indices) over the last 10 years in dollars and local currencies. The indices are scaled so that their all-time high is 100, but the charts allow us visually to compare recent levels with the immediate pre-crisis peaks.
Recovery has been uneven. In dollar terms, the US is the only big market where a new all-time high has been reached after the crisis; all other regions are more than 20% below the pre-crisis peak. That said, the size of the US market has pulled the developed and all-country indices close to their pre-crisis peaks. The main difference in local currencies is the stronger relative position of the UK, since the pound fell sharply after 2007. Japan remains bottom of the pile, but has been there for longer in local currency terms.
RoE has flatlined after its initial rebound: we expect it to see a second wind
The scatter-plots in charts 3-6 help gauge the extent to which these varying post-crisis performances reflect sentiment or fundamentals. They show how estimated earnings and stock prices, and earnings and trailing book values, have changed since pre-crisis peaks for the main countries and sectors within the developed (Figures 3-4) and emerging (Figures 5-6) blocs. The first chart of each pair (Figures 3 and 5) show how earnings and stock prices have moved. Most observations lie on or close to the diagonal, implying that stock moves have been clearly associated with earnings in both the developed and emerging world. Importantly, the US market itself is on the diagonal in the top right quadrant of Figure 3, with its higher price now backed by a similar gain in earnings. This suggests that its price-earnings (PE) ratio is little different to what it was – even allowing for the likely optimistic nature of analysts’ current earnings estimates noted above – at a level of around 15-16 (not shown in the chart). This is far from outlandish. Most dots in Figures 3 and 5 are above the diagonals, suggesting that regional and sector-specific PE ratios are, if anything, lower than at their pre-crisis highs.
Figure 3 also shows that, with the US, only Denmark, Switzerland and Sweden have reached new post-crisis all-time highs in US dollar terms, and that other European countries have the most catching up to do. From a sector perspective, the picture is exactly split with five sectors exceeding pre-crisis levels, while the others still have to recover. Financials lags most, while Health Care is nearly 50% above the pre-crisis peak, with Information Technology the sector where earnings have increased the most.
Stock moves have been clearly associated with earnings
In the emerging world (Figure 5), five small markets only – Indonesia, Malaysia, Thailand, Colombia and Philippines – are above their pre-crisis highs. Taken together they only account for 11% of the emerging markets equity universe, so their impact on the overall index is limited, and it trades 30% below its pre-crisis high.
Figures 4 and 6 plot trailing earnings, as opposed to estimates, for the coming 12 months, alongside book value, to show how profitability has moved since the crisis. Earnings divided by book value is return on equity, or RoE, and so a dot below the diagonals, showing that book value has risen by more (or fallen by less) than earnings, indicates that profitability has fallen since the crisis. This is the case in most developed and emerging markets, and could be a cause for concern if sustained. In practice, in the developed world at least, it likely reflects a reduction in leverage since the crisis, and an accumulation of unproductive cash on many balance sheets, rather than a worrying slide in operating margins or asset turnover. And the shortfall is modest. Figure 7 plots developed world RoE and shows that the current reading is only marginally below the 10-year moving average. As economic growth continues, and deleveraging ceases, we expect RoE to push back above its trend for a while.