- The US market is not necessarily expensive: valuations are high primarily in the technology sector, while the rest of the market is at fair value. Working from home, telemedicine, streaming, etc. are trends that favour the tech sector.
- Markets do seem to have recovered too far, too quickly given the uncertainty about the depth and duration of the downturn and a correction is still probable. But if the negative sentiment reflected in gold and bond yields turns out to be overdone, and the fall in GDP is less than the most extreme estimates indicate, valuations are not unreasonable.
- At a sector level, digital and healthcare have seen better-than-expected growth.
In the US, 47 companies have reported so far. Earnings fell by 32% year-on-year. With the exception of financials where bad loan provisions were higher than analysts expected, results in all sectors beat expectations by 8.2%. Sales growth was also better than forecast (see Exhibit 1).
Even though results for this and the next several quarters are inevitably going to show negative growth rates, the more negative they are now, the better the comparable figures will be in the subsequent quarters.
If earnings per share (EPS) falls by just 13% this year and is followed by 22% growth in 2021, the rebound we have seen in the market over the last several weeks is not so odd (see Exhibit 2). The fact that earnings surprises so far have been positive suggest that analysts’ forecasts are not necessarily far out of line.
Not only have reported results been surprisingly strong, the (limited) guidance that companies have given about the earnings outlook has actually been slightly more positive than it was during the same period last year (see Exhibit 3). Nonetheless, several companies have refrained from giving any outlook due to the high degree of uncertainty about how government support measures evolve.
The issue of course is whether the rebound in earnings will be as robust as consensus estimates suggest. While the US and some countries in Europe are making plans to loosen restrictions, others are prolonging their lockdowns and even in the US, some state governors are unlikely to follow President Donald Trump’s lead.
The risk remains that a relaxation of social distancing measures leads to a renewed spike in infections and deaths, necessitating the re-imposition of the lockdowns. In any event, people are unlikely to quickly return to restaurants, travel, or work if they fear for their own health.
How to value equities
Between the collapse in earnings expectations and the rally in the market, next-twelve-month (NTM) forward earnings estimates have returned to where they were before the sell-off, at 19.2x.
In a market where earnings are temporarily depressed, however, a NTM forward price/earnings ratio (PE) is not the best way to measure valuations, as it will overstate how expensive the market is.
Better alternatives are price-to-book measures and price-to-second-twelve-month (STM) earnings, that is, earnings two years out. While a two-year forward forecast is inevitably uncertain, it should be a better estimate of market value.
On a price-to-book basis, the broad US market still seems expensive. The z-score of the current multiple is 0.7 based on data since 1974, but the PB ratio, unlike the NTM PE, has not returned to pre-sell-off levels. Europe’s ratio, by contrast, is below average with a z-score of -0.4.
The US market multiple is heavily distorted, however, by technology. That sector’s multiple is high, as it has been for the last year, but the multiple for the rest of the market has fallen back to average.
STM estimates tell a similar story. The broad US market appears expensive, but primarily because of technology. The rest of the market is near fair value, and Europe is trading at a discount.
Expensive US equities? Not necessarily
The risk in the US market is not that it is necessarily expensive. Multiples are high mainly in the technology sector, while the rest of the market is at fair value. Accelerated working from home, telemedicine, streaming, etc., trends favour the tech sector. Its long-term earnings growth estimates have risen this year, while they have fallen for the other sectors.
Markets do seem to be ahead of themselves: a 6.2% collapse in GDP in 2020 à la Goldman Sachs is not commensurate with the mere 14% fall in earnings shown in Exhibit 2. A correction is likely.
However, if the negative sentiment reflected in high gold prices and low Treasury yields is overdone, and the fall in GDP is less dramatic, we believe current market valuations are reasonable.
Any views expressed here are those of the speakers as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
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