Against the tide: Equity red lights are flashing

By:
David Roche
Published on:

Investors ignore valuation at their peril – a period of lacklustre returns looms. The Fed’s move on interest rates is key.

The tortuous negotiations between the Greek government and its creditors have occupied huge amounts of media space and used up the air miles of EU ministers. But much more important for global markets are the prospect for corporate earnings and, of course, when the Federal Reserve might act to hike US rates for the first time in nine years.

Quantitative easing has done financial markets the power of good, but less so the real economy. Since the depths of the post-Lehman despair in the fourth quarter of 2008, multiple-expansion has flattered investor returns as all the central bank liquidity seeped its way into equity and bond markets. Despite profit margins being at record levels in the US, only 60% of the rise in the S&P500 price index can be justified by underlying earnings growth. In Europe and Japan the role played by expanding price-to-earnings ratios has been even more dramatic.

Feast and famine

A host of long-range valuation measures are beginning to suggest that the last seven years of feast have run their course. With central banks remaining cautious on policy normalization, this may not automatically evolve into seven years of famine. But the probability of a period of lacklustre returns is high. And the risk of a more substantial correction is growing.