In focus - Managers' views

Which stock markets look ‘cheap’ after strong performances in the first quarter of 2019?

Those who were brave enough to fight the emotional urge to sell during the carnage in markets which brought 2018 to a close have been richly rewarded in the first few months of 2019.


Duncan Lamont, CFA

Duncan Lamont, CFA

Head of Research and Analytics

Those who were brave enough to fight the emotional urge to sell during the carnage in markets which brought 2018 to a close have been richly rewarded in the first few months of 2019.

Of the five markets in our regular analysis, even the worst of the bunch (Japan) returned almost 8% so far this year (as of 12 April).

The US was the best with a 13.9% gain, an almost mirror image of the 13.7% it lost in the fourth quarter of 2018 (although this also provides a useful reminder that, because of the way returns compound from one period to the next, a given gain will not be enough to offset a loss of the same magnitude – the return over this six month period was -1.7%). The UK, Europe and emerging markets have all risen close to 10% this year.

Valuations are one of the most powerful indicators of long term returns. Buy when markets are “cheap” and the odds are stacked in your favour. Buy when they are expensive and, although you won’t necessarily lose money, more things have to come right for you to come out on top.

We highlighted in our January update that a combination of robust earnings growth and falling markets had brought stock market valuations around the world close to their cheapest level for several years. Although short term risks were elevated, the longer term case had improved notably.

Although valuations are usually a poor guide to short term performance, markets have clearly rallied sharply from that nadir. However, the strength of performance in the early stages of 2019 means that returns, which were expected to have been earned over the medium to long term, have instead been harvested in barely three months.

This leaves less on the table for the future and the valuation case is now a lot more subdued. Simple models of expected returns linked to either dividend yields or earnings yields suggest that long term expected returns are around 0.3-0.4% lower in all markets than they were at the start of the year.

This more downbeat picture can be seen in our usual valuations table, which has more of a red hue than in January. However, a closer look at the numbers suggests a more nuanced stance is appropriate.

For non-US markets, those valuation indicators which are in expensive territory are pretty close to historic averages, with the exception of cyclically adjusted price to earnings (CAPE). A cautionary note but not something which should keep long term investors awake at night.

Bad performance could of course happen (a restarting of interest rate hikes in the US would be one possible driver) but valuations are unlikely to be the source of the problem. The US continues to be out on a limb. But betting against it has been a fool’s game for years and investors would be wise to maintain a balanced exposure to global stock markets.


A few general rules

Investors should beware the temptation to simply compare a valuation metric for one region with that of another. Differences in accounting standards and the makeup of different stock markets mean that some always trade on more expensive valuations than others.

For example, technology stocks are more expensive than some other sectors because of their relatively high growth prospects. A market with sizeable exposure to the technology sector, such as the US, will therefore trade on a more expensive valuation than somewhere like Europe. When assessing value across markets, we need to set a level playing field to overcome this issue.

One way to do this is to assess if each market is more expensive or cheaper than it has been historically.


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