MARKT & ECONOMIE - FOR PROFESSIONAL INVESTORS

Goldilocks and the valuation bears

21/aug/2017
By Kate Moore

The world is enjoying a “Goldilocks” economic recovery – strong enough to keep markets afloat but not so hot as to prompt rapid monetary tightening. Yet many investors are skeptical about equity valuations after an eight-year rally. We delve into valuations today – and their usefulness as a gauge over time.

Equity highlights

  • We find that starting valuations have historically been a poor indicator of future equity returns in the short run. They show a strong relationship with long-term returns in the U.S., but have been a less reliable guide in other markets.
  • Market composition matters. For example, the U.S. valuation premium over Europe vanishes when a handful of fast-growing technology stocks is removed. Regions or indexes with a greater share of higher-margin sectors may trade at sustainably higher valuations, we believe.
  • Elevated equity valuations today could drag down future returns, but we expect dividends and earnings growth to pick up the slack over the medium term. We believe valuations are not as stretched as they may appear – multiples are unlikely to revert to historical means in a world of structurally lower interest rates.

Snapshot

We first composed a blend of five key valuation metrics – including forward price-to-earnings ratios and price-to-book value. We then examined how strong the relationship was between starting valuations – or valuations at the time of purchase – and the variability of subsequent U.S. dollar returns over time. We ran this analysis over almost three decades of equity market history in the U.S., Europe and Japan, and roughly two decades in emerging markets. Check out the results in the chart below. My takeaway: There is a strong relationship between starting valuations and long-run returns in the U.S., but less so in other regions.

Calling all crystal balls
Starting valuations and equity returns, 1990-2017

Chart: Calling all crystal balls

Sources: BlackRock Investment Institute, with data from Thomson Reuters and Worldscope, July 2017.
Notes: The coefficient of determination measures the strength of the statistical relationship between valuations at the time of purchase and subsequent stock market returns for various holding periods. Valuation is an equal-weighted blend of five measures (forward price-to-earnings, trailing price-to-earnings, price-to-book value, price-to-cash, and enterprise value to earnings before interest, taxes, depreciation and amortization). The regression analysis takes equal-weighted averages for each holding period since 1990. The markets are represented by Worldscope indexes. Returns are in U.S. dollars.

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Chief Equity Strategist
Kate Moore, Managing Director, is Chief Equity Strategist for BlackRock and is a member of the BlackRock Investment Institute.

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