Since the 2009 bear market reached its nadir many developed equity markets have, buoyed by unprecedented central bank intervention, moved inexorably upwards and ridden out periods of uncertainty caused by the US downgrade, the eurozone crisis and the Chinese stock market crash in the process. The timing of Fed interest rate rises is talked up as the next great uncertainty but, having been on the horizon for so long, a change is surely priced in to some extent.
While UK and US stocks have proved robust in the face of uncertainties in the past six years, heading into 2016 investors will question whether these markets still offer decent value. Over the past six months, several investment houses have opined that current price levels suggest better relative returns for eurozone and Japanese equities in the medium term, although there are factors weighing on these markets, too. For example, with the strength of earnings growth questionable for European companies, investors face testing times in seeking out the best returns.
On a positive note, however, thanks to low-cost exchange-traded funds (ETFs) it is easier than ever before to make advantageous tactical asset allocation tilts.
What are the best tools for valuing markets?
So, what ways are there to identify equity markets with the best prospects for 2016 and beyond? Most investors will be familiar with tools such as the price/earnings ratio (PE), which at the market level is the overall index price divided by trailing 12-month earnings. In extreme circumstances, such as in the final quarter of 2008, the conventional PE can behave erratically and it has become common for analysts to use a multiyear average of earnings.
Most famously, the cyclically adjusted price earnings (CAPE) ratio, formulated by Nobel Prize-winning economist Robert Shiller, flattens out the effect of short-term peaks and troughs in PE by taking the inflation-adjusted 10-year average of earnings as its denominator. By this measure, the S&P 500 is looking expensive, trading on a CAPE of 26.19 as of 26 October 2015, compared with its long-term average of 16.64 (Source: Online Data Robert Shiller, Yale). Of course, this average covers a very extensive period of time and critics point out that CAPE is a rather blunt instrument. After all, the ratio has been above 20 for the S&P 500 since December 2009 and had investors pulled out of US stocks then they would have forgone an 86.53 per cent gain even before dividends.
The cornerstone of modern portfolio theory is the idea that more volatile investments should be compensated by a higher rate of return. Another approach to valuing equities therefore, is to consider the premium over less risky assets, such as government bonds, implied by current index prices. The table below shows Morgan Stanley's 10-year expected annualised returns for major equity regions and the premium over 'risk-free' government bonds. For the US, Europe and Japan, we use Morgan Stanley's estimated risk-free rates, which are calculated for each region based on the yield for corresponding government bonds adjusted for roll-down (the way a bond price converges towards par as it reaches maturity). For emerging markets, we have chosen to take the US risk-free rate.
| Region and index | Nominal implied return annualised | Annualised risk-free rate | Equity risk premium |
|---|---|---|---|
| US (S&P 500) | 5.0% | 2.7% | 2.3% |
| MSCI Europe | 5.6% | 1.3% | 4.3% |
| MSCI Japan | 3.6% | 0.3% | 3.3% |
| MSCI EM | 7.8% | 2.7%* | 5.1% |
Source: Morgan Stanley Research (*Investors Chronicle decision to re-use US risk-free rate for EM)
Implied risk-adjusted returns
The next thing to consider is how the premium on offer for investing in the different equity indices, compares to trailing volatility. By this measure, European stocks are priced for the best risk-adjusted returns over the next decade, with Japan and emerging markets also looking preferable to the US.
| Region and index | Equity risk premium | 10-year volatility | ERP/Vol |
| US (S&P 500) | 2.3 % | 17.1% | 0.13 |
| MSCI Europe | 4.3 % | 17.7% | 0.24 |
| MSCI Japan | 3.3% | 19.4% | 0.17 |
| MSCI EM | 5.1% | 25.1% | 0.20 |
These figures seem to agree with the CAPE ratio that the S&P 500 is not attractively priced relative to other investments. Neither valuation model should be taken as a signal to be out of the US entirely, but they do suggest that, in the long term, the equities portion of overall asset allocation should be skewed towards other regions.
Factor tilts offer a more nuanced approach
Most institutional asset allocations have been overweight European equities for the past year. Although the equity risk premiums imply they remain attractive, there are interesting anomalies that have occurred as more investors have bought European shares. Most strikingly, according to Morgan Stanley research, the top quartile of 'quality' European stocks are actually overvalued compared with their US counterparts. This is explained by European investors having had a significant bias to defensives, coupled with a tendency to equate quality characteristics (such as past return on equity, dividend stability, balance sheet strength etc) with defensive shares. Measured by normalised price/earnings (earnings having been adjusted to flatten out cyclical peaks and troughs in the economic cycle) US quality is only 0.9 times as expensive as European quality. There is a case therefore for introducing a quality bias to US equities exposure.
Conversely, it is companies with more of a value tilt (such as a lower price-to-book or price-to-cash flow ratio) that are behind Europe's cheaper overall valuation. The European Central Bank (ECB) disappointed markets with the scale of its continued intervention, announced in December. In light of this, it is probably prudent to maintain a broad market-cap-weighted European exposure rather than looking to add risk with a specific factor tilt. Should investors wish to take a contrarian short-term view, there are value-tilted European equities ETFs available and this may be an option when the European growth picture stabilises.
What about the UK?
In terms of the UK market, one major uncertainty is the possibility of 'Brexit' as the country votes whether to remain in the European Union. The likelihood of the outcome being close creates potential for cyclical swings in economic activity, corporate profits and asset prices. Where investors could take advantage of this uncertainty is in the valuation of FTSE 100 companies. If concerns over the referendum outcome drag on share prices, some bargains could be had. In any case, mega caps have the lowest sales exposure domestically (8 per cent) and to continental Europe (12 per cent) of the UK stock market, so whatever the result of the poll, UK companies with global scale should be fine.
Modelling the precise effect on share prices of a political event is not really feasible, but a more quantifiable reason for a tactical tilt towards larger UK companies is their relative valuation to international peers. Whereas FTSE 250 companies are (based on the composite average of price/earnings, price-to-book value and price to dividend yield) relatively much more expensive than world mid-caps, overall UK equities are 3 per cent below their long-run relative valuation to European stocks. This implies that FTSE 100 companies are not overpriced. Furthermore, the spread of the FTSE 100 dividend yield over that of the 250 is, at 1.15 per cent, at near-record levels. Given the potential uncertainties in 2016, the preference would be to concentrate UK exposure in the FTSE 100.
Broad asset allocation
Looking at research from Morgan Stanley and Goldman Sachs, there is consensus that government bonds will underperform for 2016, although Morgan Stanley prefers US Treasuries and Goldman Sachs prefers German Bunds. The higher risk-reward fixed-income play is on US corporate high-yield.
Goldman Sachs remains underweight towards commodities, citing the risk of further falls in oil prices due to lack of storage capacity and mild weather. Its prediction is for a slower rate of decline in 2016 than was seen this year, but with the expectation of further falls in the first quarter. On balance, it is probably best to remain on the sidelines for now, but for investors who wish to take a position on the recovery of commodities, it may be worth waiting for signs of an upturn in the second quarter of 2016 and there are products available that exclude energy if there remains slack in the oil price. JN
