The FTSE 100 and S&P 500 may have reached all-time highs in recent months but how much further might they and other equity markets rise? Regular visitors to The Value Perspective will be well aware of our belief that valuation is an excellent guide to how markets may behave in the long run but will also know that, over the shorter term, we would concede you might just as well consult an astrologer.
We have data stretching back to 1927 that shows how the UK market has fared over various time periods after being on different valuations and, when it has been on a comparable valuation to today, it has gone on to return an average of between 3 - 4% a year – whether over an ensuing period of one, three, five or 10 years.
Aha, we hear you all shout, you mentioned one year and yet you always describe that as the shorter term, don’t you? Indeed we do – and that is why we are much more comfortable with our data over the longer run. Put simply, that 4% average over one year masks a very wide dispersion of returns – a dispersion that narrows significantly as the time horizon lengthens.
Put even more simply, over 10 years that dispersion ranges from an upper level of 13% to a lower level of -3% to reach the 4% average whereas, over one year, the range is in the order of +38% to -62% and thus completely unusable. Unusable, that is, except as the start of a hypothetical exercise – what would it take to trigger either of those two extremes over the coming 12 months?
Starting with the potential upside, we would posit the so-called ‘the M&A gap’ could drive markets to new and crazy highs. The global stockmarket has only ever been at the level it is now on two previous occasions – and both times there was some $4 trillion of merger and acquisition activity going on in the world. Today the equivalent figure is nearer $2.8 trillion so maybe this gap will be filled.
This year has already seen a number of multi-billion-dollar deals in the US pharmaceutical sector alone while of course, back in the UK, we have Shell’s £47bn takeover of BG Group. With growth still hard to come by and debt rates so low – indeed negative for some mega-caps which could really move the M&A needle – it is not impossible to imagine markets catching M&A fever once more.
On the other hand – and, if we are playing economic forecaster, two hands is the minimum requirement – we could posit the very negative case that, when it is very expensive to save and very cheap to borrow, things tend to end badly. Our newfound willingness to posit does not extend to speculating on what that might be but there are clearly forces at work that are increasing risk in financial markets.
And when we say ‘forces’, we are of course referring to the world’s major central banks, which continue to indulge in a financial experiment for which there are no real precedents or textbooks. At some point it could all end in a very nasty event and a lot of tears. Or we could get the M&A frenzy. Or neither. As we say, in the long run, valuation should be your guide but, in the short term, who knows?