It’s been an incredibly tough start to the year for investors, with some market veterans describing it as one of the most challenging situations they’ve ever experienced. While markets have staged a recovery since late March, it was a crushing quarter as coronavirus (Covid-19) effectively shuttered the global economy, not to forget the immeasurable human cost.
Markets are hoping for a short, sharp recession, followed by a “V-shaped” recovery. However, significant uncertainty remains as to how long it might take for normality to return to our lives and so the economy. Some of the risks are captured by Schroders’ economists in their recent analysis of how the global economy might recover from a severe recession in the first half of this year.
They expect an economic rebound as the crisis abates, lockdown measures are lifted, business restarts, shops re-open and normal activity resumes. A key risk to this scenario is a potential return of the virus in the third quarter of this year, resulting in another shutdown in Q4 (see: V, W or L: what shape will the recovery take?).
How large have the losses been?
Some of the biggest market declines have been in commodity exporting regions like Latin America, Australia and Canada, where markets have been hard hit by the dual forces of coronavirus concerns and plummeting commodity prices (see table, above). Oil prices have fallen abruptly, compounded by the Organization of the Petroleum Exporting Countries (OPEC) and Russia failing to reach agreement over supply cuts.
Meanwhile, tentative signs of economic recovery explain why some Asian markets have performed relatively well over Q1. The region is further along in dealing with the spread of Covid-19 than the rest of the world with some Asian countries having reportedly reached peak infection rates. Lockdown measures have been lifted in Wuhan, the Chinese city where the Covid-19 outbreak was first reported.
How do regional valuations look versus their histories?
Valuation metrics should be treated with great caution given current events, particularly those metrics based on earnings forecasts that are yet to fully reflect the impact of the impending global recession.
Many companies have suspended dividend payments as they prepare for the coming economic storm and many more will inevitably follow suit. This is not reflected in the current yield of markets (see The impact of the coronavirus on dividends).
However, some regions are trading on lower valuations than other regions versus their own histories. The UK and Japan are more than 10% cheaper than their 15-year average valuations across five measures, including the cyclically-adjusted price to earnings (CAPE) multiple which is based on long-term historical earnings (see the end of the article for a definition of these valuation measures).
Emerging markets (EM) also look to be cheaper than other regions relative to their history.
Past Performance is not a guide to future performance and may not be repeated.
Risks abound but, for those who have a long enough time horizon, valuations relative to histories appear more appealing in some regions than others. The problem is that, while uncertainty persists, markets could become even cheaper. It is not the time to be recklessly bold but, if you have a long enough time horizon, some areas of the stock market are starting to look more interesting.
Emerging markets and “domestic champions”
Rory Bateman, Head of Equities, believes there could be some interesting opportunities emerging for long-term investors.
“To my mind emerging markets have been oversold during this downturn. Although 2020 earnings will be downgraded, if you believe that we’re not in for a protracted recession and that there’ll be a relatively decent bounce next year, emerging markets look attractive from a valuation perspective.”
He believes the emerging world will come out of the crisis ahead of the developed world, having been the first to enter it.
The other area that’s caught his attention is small- and mid-caps, which have underperformed in many markets, and noticeably so in the UK.
“These are primarily domestically-focused companies that will be protected to some extent by fiscal support to get them through this crisis, so we could start seeing some ‘domestic champions’ emerging”. However, he advises selectively allocating capital to those with strong balance sheets at this stage - it may well be the case that equity markets retest their recent lows given the severity of the downturn in economic activity.
A rutted road to recovery
There’s no knowing whether the worst of the stock market drops are behind us or still to come. However, long-term investors may find some attractively priced opportunities in this environment, even if the road to recovery is likely to be bumpy.
This information is not an offer, solicitation or recommendation to buy or sell any financial instrument or to adopt any investment strategy. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
Definitions of valuation metrics
When considering stock market valuations, there are many different measures that investors can turn to. Each tells a different story. They all have their benefits and shortcomings, especially in the current economic environment, so taking a rounded approach helps.
A common valuation measure is the forward price-to-earnings multiple or forward P/E. This divides a stock market’s value or price by the earnings per share of all the companies over the next 12 months. A low number potentially represents better value.
In the current economic environment earnings forecasts are yet to fully reflect the impact of the impending global recession.
This is perhaps an even more common measure. It works similarly to forward P/E but takes the past 12 months’ earnings instead. In contrast to the forward P/E this involves no forecasting, however, the coming 12 months will have very little semblance to the previous 12 months.
The cyclically-adjusted price to earnings multiple is another key indicator followed by market watchers, and increasingly so in recent years. It is commonly known as CAPE for short or the Shiller P/E, in deference to the academic who first popularised it, Professor Robert Shiller.
This attempts to overcome the sensitivity that the trailing P/E has to the last 12 months’ earnings by instead comparing the price with average earnings over the past 10 years, with those profits adjusted for inflation. This smooths out short-term fluctuations in earnings.
When the Shiller P/E is high, subsequent long term returns are typically poor. One drawback is that it is a dreadful predictor of turning points in markets. The US has been expensively valued on this basis for many years but that has not been any hindrance to it becoming ever more expensive.
The price-to-book multiple compares the price with the book value or net asset value of the stock market. A high value means a company is expensive relative to the value of assets expressed in its accounts. This could be because higher growth is expected in future.
A low value suggests that the market is valuing it at little more (or possibly even less, if the number is below one) than its accounting value. This link with the underlying asset value of the business is one reason why this approach has been popular with investors most focused on valuation, known as value investors.
The dividend yield, the income paid to investors as a percentage of the price, has been a useful tool to predict future returns. A low yield has been associated with poorer future returns. A note of caution, however: the current yield on the market does not reflect the dividends that companies will be able to pay, it is likely to begin to fall over the coming months. The question is by how much?
This information is not to be relied upon and should not be taken as a recommendation to buy/and or sell If you are unsure as to your investments speak to a financial adviser.
Investors should always be mindful that past performance and historic market patterns are not a reliable guide to the future and that your money is at risk, as is this case with any investment.