Are equity valuations still reasonable?

Are equity valuations still reasonable?

Are equity valuations still reasonable? 150 150 Piers Bolger

A question we get asked often is whether the performance of equity markets can be maintained given the low interest rate environment we’ve had since the GFC. Equity markets have recently witnessed very strong investment performance both locally and overseas. Over the last 12 months our equity market is up 15% and global markets are up well over 17%. These returns are well above the performance that we expect from an equity market over the long term, but they’ve been driven by a solid uptick in corporate earnings (principally out of the US) that has translated into higher share prices and better overall global market performance.

Low interest rates have certainly helped when you look at the performance of equities relative to other asset classes, but the fundamentals remain sound. While we don’t expect equity markets to continue to grow at ~15% year on year, we’re also not expecting a significant GFC style correction in the near term. That’s because the macroeconomic, corporate and household fundamentals are different from 2008. So while the ability for equity markets to continually move higher without periods of pullback is completely unlikely, it doesn’t mean (in our view) that we are on the precipice of another 2008/09 market correction.

As an example, if we think back to 2008 banks were willing to lend money to virtually anyone, and certainly more individuals and businesses who were not of high credit worthiness. The rise of this excessive debt resulted in individual and corporates not having the means to pay it back, causing massive defaults that ultimately found their way into financial markets. Secondly, collateralised debt obligations (CDOs) were being used heavily as a proxy fixed income product for investors – offering high income returns for little risk.   These investments were really syndicated loan offerings and in many cases the underlying credit was of poor quality. In addition, they were massively leveraged resulting in a high yield strategy that worked until the point where the credit defaulted.

The most overt example of this related to mortgage loan market, with banks packaging up multiple loans into a product to sell to other investors who may also further on sell the product with additional leverage – all based off the same collateral. This meant people would take out a mortgage over a security and then use the same collateral to get another loan. So, they were taking out loan over loan based on a single security and no one knew who actually owned the original security. Essentially, greed, excessive lending, poor credit quality, weak regulatory oversight and stretched balance sheets contributed to the GFC.

Going forward 10 years, bank lending is now much tighter and credit lending standards have improved. Corporates have become more sensible in the way they manage both their business (i.e. balance sheets, cash flow) and shareholder returns. We’re not seeing the same amount of leverage in the market and there’s excess capacity, so cash rates and interest rates will probably remain low for some time. That’s why we don’t expect there to be a significant rotation from equities into fixed income and cash-based products in the medium term and believe that equities should remain an important part of a broad portfolio.

As always, if you have any concerns regarding the particular strategies within your portfolio, it’s important to talk to your advisor.

Piers Bolger is Chief Investment Officer at Viridian Advisory

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