Special Report
Highlights Even though EM equities appear cheap, the key near-term threats to them are their poor fundamentals and a renewed sell off in the S&P 500. Given the immense uncertainty, the current equity risk premium (ERP) should be at the upper end of its historical range. Hence, the discount rate – the sum of the risk-free rate and the ERP – should be reasonably high. This makes US equity valuations rather expensive. The key risk to our defensive strategy is that the rally in global growth stocks evolves into a full-fledged mania. Feature Every investor is aware that global corporate profits have collapsed due to nationwide lockdowns and profits will eventually recover as the lockdowns are gradually eased. This thesis, though, is not helpful for equity investors. To price equities properly, investors need to know how low corporate profits will fall and how fast and strong the eventual recovery will be. Currently, visibility on the magnitude and speed of the decline in profits and the subsequent recovery is factually nil. In fact, very few companies are providing any guidance. There is enormous uncertainty surrounding the pace at which economies will be reopened, the possibility of secondary infection outbreaks and the discovery of a remedy or a vaccine for this virus. Besides, it is hard to forecast how fast animal spirits will revive among consumers and businesses worldwide. Thus, it is impossible to reliably forecast the magnitude and pace of both the decline in corporate profits and the subsequent recovery. What framework should investors use to value stocks when facing extremely low visibility? The CAPE Ratio Presently, the best method for valuing stocks is the Cyclically-Adjusted P/E (CAPE) ratio. This is a structural valuation measure that looks beyond the profit cycle, i.e., removes the cyclicality of earnings per share (EPS) from P/E ratio calculations. When the profit outlook is as muddy as it is today and the possible range of outcomes is very wide, it is safe to assume that in the next 12-18 months corporate profits will revert to their historical trend, i.e., drop below and then recover to their structural trend. This is a better conjecture than any attempt to forecast the magnitude and speed of both the profit plunge and subsequent recovery. Hence, the appropriate question for investors at this time is: what is the forward P/E multiple on equities assuming that EPS will plummet and then recover to their historical trend over the next 12 to 18 months? The CAPE model provides the answer to this question. Presently, the best method for valuing stocks is the Cyclically-Adjusted P/E (CAPE) ratio. Chart I-1 illustrates our EM CAPE model, showing EM equities as cheap as they were at previous major bear market bottoms. The EM CAPE is presently 12.5 assuming EM EPS plunge further in the coming months but recover to their long-run trend in 12-18 months from now (Chart I-1, bottom panel). Our measure for US CAPE presently stands in high 20s, well above its historical average of 18 (Chart I-2). Chart I-1EM Equity Valuations Are Low Chart I-2US Equity Valuations Are Expensive Box I-1 on page 3 elaborates how our CAPE model is built and how it differs from Shiller’s CAPE ratio. Even though EM equities are very cheap, the key near-term threats to them are two-fold: (1) EM fundamentals remain downbeat, which is creating a near-term risk to share prices; and (2) a renewed sell off in the S&P 500 would drag EM stocks lower, despite cheap EM equity valuations. In the next section, we explore US equity valuations in a bit more detail. BOX I-1 Our CAPE Versus The Shiller CAPE: Differences In Methodologies Due to the lack of historical data for EM, we were unable to use Robert Shiller's methodology for constructing the CAPE ratio for developing markets. The Shiller method uses a 10-year moving average of EPS to calculate the cyclically adjusted EPS. However, in the case of EM aggregate EPS, data only goes back to 1986. If we were to calculate a 10-year moving average for EM EPS, we would lose 10 years of data, and the valuation indicator would only start in 1996. This is too short a time-frame for a structural valuation indicator. Chart I-3Comparing Two CAPE Methodologies Instead, we used the following methodology to construct the CAPE ratio for EM: We deflated EM EPS and EM equity prices (both in US dollar terms) by US consumer price inflation to get EM EPS and EM share prices in real (inflation-adjusted) US dollar terms. Then we ran a regression of EM EPS in real US dollar terms against a time trend. The resulting trend line represents the cyclically adjusted or structural EPS in real US dollar terms (Chart I-1, bottom panel on page 1). Finally, we divided EM stock prices in real US dollar terms by the cyclically-adjusted real US dollar EM EPS trend line. The outcome is the EM CAPE ratio (Chart I-1, top panel on page 1). To be sure that our methodology produced a reasonable outcome, we computed a CAPE ratio using our methodology for the US stock market and compared it with the Shiller CAPE ratio. Chart I-3 illustrates that our methodology generated a CAPE ratio that is similar to Shiller’s CAPE ratio. We are therefore confident that the results generated by our CAPE methodology are robust and sensible. Low Visibility = High Equity Risk Premium Chart I-4CAPE Ratio Negatively Correlates With Corporate Bond Yields It is a well-known fact that US equity multiples are very high. However, a common narrative in the investment community often justifies currently high US equity multiples by very low interest rates. One consideration that is missing in this argument is the equity risk premium. The P/E ratio is negatively correlated to the discount rate.1 The discount rate is the sum of the risk-free rate and the equity risk premium (ERP). Chart I-4 demonstrates that US CAPE ratio has been inversely correlated with corporate bond (BAA) yields. The latter includes both risk-free government bond yields and corporate credit spreads. Presently, one should use an ERP that is materially higher than its historical mean. Investors are currently facing record high uncertainty related to the business cycle as well as the structural trends in economic, political and geopolitical spheres. In short, enormous lingering uncertainty warrants using an ERP that is at the upper range of its historical trend. Critically, ERP is not a static variable. Yet, many equity valuation models assume that the ERP is constant and, therefore, compare equity multiples with risk-free rates. Such models are wrong-headed because a change in the ERP can in itself cause large fluctuations in share prices. Chart I-5Estimated US Equity Risk Premium Going forward, visibility on both the evolution of the virus containment measures and the global business cycle will eventually improve and, thereby, decrease ERPs that investors require. This will produce a lower discount rate heralding higher equity multiples. As of today, however, the tremendous uncertainty about the outlook still warrants a higher ERP. Chart I-5 illustrates that the US ERP based on our CAPE model is presently 270 basis points. It is elevated but still below historic peaks recorded in 2008 and 2011. Provided we face extremely limited visibility about the global outlook, we contend that the US ERP will likely rise in the short run. The latter will depress US equity valuations and prices. Bottom Line: Given the immense ambiguities investors are facing in regard to the business cycle and to economic, political and geopolitical trends, the ERP should be at the upper end of its historical range. Hence, the discount factor – the sum of the risk-free rate and the ERP – should be reasonably high. We conclude that US equity valuations are rather expensive despite the very low risk-free rate. Falling US stocks will drag EM share prices lower. EM Versus The S&P 500: Three Conditions For A Reversal Chart I-6Relative CAPE Ratio: EM Versus US The relative EM versus US CAPE ratio is shown on Chart I-6. According to it, EM equities relative to their US counterparts are as cheap as they were at their previous major bottom in 2001. Nevertheless, valuation is not a good timing tool. For EM to start outperforming the S&P 500, three conditions are required: 1. China’s economy should embark on a cyclical recovery that is greater than the natural snapback in activity that it has been experiencing in the wake of the end of its lockdown. So far, the mainland economy is still in a snapback phase rather than in an expansion mode. 2. Global equity sector leadership should rotate from growth to value stocks, such as resource-related and banks. This has not occurred yet. The EM equity index is more sensitive to the performance of financials than the S&P 500 is. Table I-1 and I-2 represents individual EM and US sector weights in terms of both market cap and total corporate earnings in their respective equity benchmark. Financials account for 36.6% of EM total earnings and 20.9% of EM market cap. The same ratios for US financials in America’s broad equity index are 22.2% for earnings and 10.5% for the market cap. Table I-1EM Equity Sector Earnings And Market Cap Weights Table I-2US Equity Sector Earnings And Market Cap Weights Further, EM equity prices remain highly correlated to global materials stocks (Chart I-7). As we discussed in our October 10, 2019 report, the rationale is as follows: both industrial metal prices and EM equities are driven primarily by China. Enormous lingering uncertainty warrants using an ERP that is at the upper range of its historical trend. 3. The US dollar should enter an extended bear market. The greenback has been resilient despite the Federal Reserve’s outright debt monetization and the general risk-on mood in global equity and credit markets. Further, the EM ex-China currency index has failed to rebound despite the noteworthy rally in the S&P 500 since late March (Chart I-8). Chart I-7EM Stocks Correlate With Global Materials Chart I-8EM Currencies Have Failed To Rally For the greenback to depreciate, US dollars should be recycled overseas via augmented US imports or capital outflows from the US. It seems that none of this is currently taking place. The dollar is probably experiencing the last leg of its structural bull market that commenced in 2011. In financial markets, the final phase of a structural trend can last longer and run further than many investors expect. Odds are that the greenback will overshoot before topping out. Chart I-9 presents the real effective exchange rate for the US dollar, the euro and the Japanese yen, based on unit labor costs. This is our favored currency valuation measure. It reveals that the greenback is already expensive, but that its valuation can become even more expensive and reach two standard deviations above fair value before the US dollar peaks. In turn, according to the same measure, valuations of commodity currencies like NZD, AUD and CAD have downshifted considerably (Chart I-10). Nevertheless, they are not yet very cheap. Therefore, further undershoots cannot be ruled out. Chart I-9G3 Currency Valuations Chart I-10Commodity Currencies Valuations Bottom Line: The conditions for EM stocks to begin outperforming the S&P 500 have not yet been satisfied. EM outperformance is not imminent. The Key Risk The key risk to our strategy of not chasing the recent equity rebound is as follows: The rally in expensive global growth stocks could evolve into a full-fledged mania. The latter would then lift the broader equity index, including value stocks. The average retail investor in any corner of the world can now make the case for an exponential rise in growth stocks: major central banks are printing money, risk-free interest rates are at zero, businesses in “new economy” are relatively immune to COVID shutdowns and, moreover, they represent the future. All conditions for a bubble formation are present: a concept that captures the average person’s imagination, good fundamentals and solid past performance, as well as liquidity overflow. Growth companies that are leading this rally are very expensive and over-owned while the laggards – the value stocks – have a ruinous profit outlook. The only problem with this thesis is that these stocks have already rallied massively over the past decade and are consequently expensive and over-owned (Chart I-11). Chart I-11Each Decade Had A Mania Can they still go higher, dragging up overall equity indexes? They can, as the human imagination has no limits. If retail investors continue piling up on stocks – and there is some evidence they have been doing so – share prices will rise despite the expensive valuation of growth companies and the disastrous profit outlook for value stocks. Like any bubble, this mania, if it occurs, will eventually culminate with a crash. Investment Conclusions Chart I-12Growth And Value Stocks EM equities have become cheap and oversold, which is why we closed our short position in EM stocks on March 19. Nevertheless, we have not yet recommended buying or overweighting EM stocks. The near-term outlook remains risky and EM valuations could remain depressed for a while given that investors currently face zero visibility. Consistently, the risk-reward of global and EM equities is yet not attractive. The basis is as follows: Growth companies that are leading this rally are very expensive and over-owned while the laggards – the value stocks – have a ruinous profit outlook (Chart I-12). For now, we continue recommending underweighting EM versus DM equities. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnote 1 The P/E ratio inversely correlates to the discount rate: P/E ratio = (Payout rate x (1 + Growth rate)) / (Discount rate – Growth rate)
