Fears of overvaluations and bubbles abound but strategist says supporting data reveals otherwise
Sometimes, things can just feel too good to be true. It may be why some believe the broader market is overvalued and why asset bubbles like Bitcoin are stark warnings of an impending pull back.
But Kevin Headland, senior investment strategist at Manulife Investment Management, said the strong move higher in valuations from the equity market lows last year is no surprise, especially after three quarters of negative earnings growth on a year-over-year basis and at a time when the U.S. government and the Federal Reserve were “providing ample liquidity".
He said: “The Fed has been very successful with this iteration of quantitative easing, with the money supply - as measured by M2 - up 25% year-over-year. When the money supply increases, stock prices tend to go up. We can point to some segments of the market that are overvalued or overextended but we’d hesitate to characterize the broader market as in a bubble.”
Instead of a traditional bubble, Headland prefers to think of broad equity valuations as a lake that’s frozen over. He explained that when a lake begins to freeze, it’s typically gradual, and it tends to thicken as the weather gets colder.
“The biggest risk is not knowing how thick the ice is, as you can’t see that from the surface. If you don’t know how thick the ice is, how willing would you be to walk, or snowmobile, to the middle of the lake? If the ice is too thin, there’s a bigger risk that it might crack. You don’t know when, where, or how it will crack, but the risk is elevated as the ice starts to thin out.
“Could the same be said about equity market valuation: the more stretched the valuation, the thinner the ice and the greater the risk?”
If you look at the valuations of the market right now, whether it’s price-to-book, price-to-sales, price-to-cash flow or price-to-earnings, they all reveal that the S&P 500 is towards the upper range of its 20-year history.
These “stretched valuations” are driving fears of a valuation correction in the equity markets and it would appear that the market is “walking on thin ice and any misstep may cause a crack”. But Headland insisted that when it comes to valuation, the true measure of “thickness” comes down to how strong the supporting data is.
He said: “Although the current market valuation looks to be on thin ice, we’d argue that it’s supported by improving fundamental data. A strong equity market recovery is typically started by a valuation expansion then followed by a transition to an earnings recovery.”
In an earnings recovery, he said we tend to see valuations contract. Headland pointed to Manulife research that showed that during periods when earnings growth is greater than 30% on a year-over-year basis – as Manulife believes it will be in 2021 - the average price-to-earnings contraction is 4.1 multiple points. During these periods, and despite the fall in valuation, the average and median 12-month returns for the S&P 500 Index are 10.2% and 12.4% respectively.
He added: “We believe 2021 will be no different. After three quarters of negative year-over-year earnings per share growth, the earnings recovery has begun. We believe 2021 earnings may not only reach 2019 levels but exceed them, supported by strong fundamentals.
“Valuation, regardless of the method of calculation, can’t indicate by itself how thick or thin the ice is. You need to be able to see what’s supporting that top layer. We’ve had times when valuation levels were below where we are today and would be cause for extreme caution. However, because of the strong underlying support and the expected positive market environment in 2021, the ice is probably a lot thicker than it may appear.”
