Valuing quality stocks

It took the S&P 500 only five months to recoup its pandemic-related losses and reach new all-time highs. On the other hand, global economic activity remains considerably below pre-crisis levels. This divergence is unlikely to last forever. However, a sustained, sharp correction may not be on the cards for the time being.

A valuation-driven rebound

While stock prices have swung dramatically between February and August, the same can’t be said about earnings expectations. Indeed, 2020 estimates shrank to $122 at their trough in July, from $172 at the beginning of the year (see chart). They stand at $128, having barely moved despite stellar second-quarter results. For 2021, the earnings per share for the S&P 500 are expected to reach $165, broadly in line with the $163 reported in 2019.

With earnings expectations well anchored, the main driver of the stock market’s rally has been the expansion of valuation multiples. The S&P 500 is trading at 22 times, on a 12-month forward price-to-earnings ratio basis, significantly above historical averages. Despite equities move higher during earnings season in July and August, this number has been relatively stable as the next four quarters now include a period, between April and June 2021, when consensus expects profits to jump by 40% year-over-year.

All about multiples

While it’s fairly easy to rationalise changes in earnings expectations, explaining gyrations in valuation multiples is subject to interpretation. Price-to-earnings ratios typically lead earnings revisions and collapse in anticipation of contracting earnings while expanding ahead of a recovery.

As such, it should not be surprising to see elevated valuation multiples when earnings expectations are depressed and about to be revised higher (see chart). However, as we have established above, the consensus already expects 2021 earnings to be back to 2019 levels, leaving limited room for additional positive revisions.

Central banks in control

The reason behind the recent dramatic increase in valuations seems to lie outside of earnings expectations or valuations. But where?

One likely explanation could be the unprecedented injection of liquidity from central banks. While some of the measures announced during the pandemic were solely designed to help financial markets function normally, the ramp up in quantitative easing, coupled with the unconditional commitments from the European Central Bank (ECB) and US Federal Reserve (Fed) to do “whatever it takes” to support their economies, have made the institutions buyers of last resort. This has removed some of the risks investors would normally bear, reducing the premium needed to cover these risks and allowing valuations to expand.

Don’t fight the Fed still

If central banks’ supportive policy actions are indeed responsible for inflating equity valuations, then any sustained and meaningful fall in valuations looks unlikely while liquidity remains plentiful.

With both the Fed and ECB appearing far away from reducing asset purchases, valuations can hold for now, allowing an upward reversion to the mean on the back of gradually recovering earnings. At the same time, markets tend to respond most directly to the flow rather than the stock of monetary easing. With the pace of accommodation likely to slow in coming years, further multiple expansion is improbable.

Choppy sailing

If equity valuations are to hold, a repeat of March’s severe selloff is unlikely. Yet, uncertainty remains elevated. Indeed, whether it is US-China trade tensions, the US presidential election or simply the pace of the recovery, the road ahead appears bumpy.

As such, we would not dismiss the possibility of a five to ten percent correction, especially should governments fail to maintain a high degree of fiscal support or should a COVID-19 vaccine be elusive this year.

Timing a possible entry point will be difficult if not impossible. This is why staying invested may be an appropriate course of action. However, diversification is likely to be key to successfully navigate equity markets this year.

Look beneath the surface

Even though, at the index level, price moves should be rather limited, investors should prepare for higher volatility and dispersion at sector and stock levels. In particular, the over dominance of “growth” as an investment style, spearheaded by tech this year, may temporarily come under pressure should the health crisis recede if and when a vaccine becomes available.

Yet, investors should not completely rotate away from growth (technology, internet or healthcare for example) and into value sectors (such as banks or energy). Instead, “quality” remains the main characteristic worth considering when investing, whether its within growth or value.

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

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