Why I can stomach higher equity valuations

The rising involvement of retail investors has been an intriguing trend during the pandemic, culminating in the surge and slump of GameStop shares.

As an industry, we worry about the disconnection of individual investors from financial markets, the hubs of wealth creation. Direct ownership of shares by individuals has been declining for decades. For that reason, the growing fervour for stock investing that had been growing throughout 2020 should be welcomed. The more recent encouragement of novice investors to buy wildly inflated stocks, however, should not.

For many, GameStop shares will be the one and only time they buy a stock, left only with a memory of their part in the “angry bubble” and a stinging loss. I worry about the risks being taken at a time when wealth and health is already a pressing concern.

We have seen retail investor exuberance pervade markets before. Back in January 2000, working as a young analyst I was among the buyers of tech start-ups. It’s easy for new investors to be engulfed by speculative fever.

The rise of the lockdown investor has been explored before with our observations on the growth of the Robinhood trading platform during lockdown 1. But then, as now, my focus was on valuations and the other critical factors driving markets.

Our expectation that vaccines would provide a shot in the arm for recovery stocks has proven so. Markets have risen quite a way since then and valuations for major markets look expensive against historic norms, but it’s not a reason to stop believing in equities.

As we struggle with home-schooling and dark days, it is easy to feel dejected. However, we should start to see the benefit of vaccines in the US and the UK as we move into the spring. Green shoots are beginning to emerge and central banks will not want them to be trampled by tightening monetary policy.

Quite simply, the sheer scale of economic stress created by lockdowns makes the unwinding of stimulus measures unlikely, a view reinforced by the Federal Reserve in January.

This leaves us to ponder a scenario where economies recover and bond yields stay low, which helps to underpin equity valuations. Markets feel bubbly but bubbles tend to get pricked by higher rates. For now, the central bankers are keeping their needles safely tucked away.

What about inflation? There’s much talk of the Roaring Twenties and the subsequent price pressure that could ensue, but it’s too early to be concerned. There is little evidence of dangerous inflationary pressure. In fact, a little inflation would support the story of global recovery yet wouldn’t be enough to prompt central banks to raise rates.

I can therefore stomach the risk of higher valuations in equities. As we lift our heads and move into spring, the news on the virus may continue to improve. At that point it might be time to take some profits and enjoy a little sunshine.