Why U.S. stock valuations may not be too badly extended

Oft-quoted measure of valuations may only tell half the story, says portfolio management firm

Why U.S. stock valuations may not be too badly extended

Against the backdrop of euphoria that seems to be prevalent in the U.S. stock market, it’s very easy to understand why concerns about valuations are so prevalent. But according to a new commentary from Picton Mahoney Asset Management, things might not be as dire as the headlines suggest.

In its Q1 2021 Investment Review and Outlook, the boutique portfolio management firm noted that while the Shiller Cyclically Adjusted Price/Earnings (CAPE) ratio is well below the zeniths it reached in early 2000, it is currently sitting at a level reminiscent of its pre-Great Depression peak.

“However, a look beneath the surface finds valuation levels more palatable than at first glance,” the firm said.

The firm noted that FAANG stocks have massively skewed the aggregate multiple of the S&P, particularly as they grew to constitute 25% of the benchmark’s market cap in 2020. Excluding those stocks, it said, reveals that the U.S. stock market is far less expensive than what’s indicated by headline numbers.

While most sectors outside technology are also seeing valuations exceeding those they’ve experienced historically, Picton Mahoney suggested that they can be explained by the significant equity risk premium (ERP) that the earnings yield on the S&P 500 currently has relative to real Treasury yields.

To illustrate, the firm derived a measure of earnings yield by inverting the Shiller CAPE ratio, and compared it to the negative real yields available from U.S. ten-year Treasury bonds. “On this measure, the U.S. equity market appears reasonably attractive (especially in more inflation-sensitive and/or cheaper non-technology equities),” it said.

Given the current sub-zero real yield on ten-year Treasuries, bond investors are likely to experience a loss of spending power as their bonds mature. Coupled with market volatility, such negative inflation-adjusted bond yields are liable to promote significant equity inflows from certain more systematic asset managers, leading to expectations of even higher stock prices later this year.

Systematic investing strategies such as risk party, volatility control, and commodity trading advisors (CTA) shifted out of equities last year, the firm noted, due to risk control processes that kicked in as the CBOE Volatility Index (VIX) jumped from 15 in mid-February to 86 in March. Such funds eventually reversed their selling activity as the markets bottomed and rallied somewhat.

“However, many of these systematic strategies remain underexposed to equities as 2021 begins,” Picton Mahoney said. “Barclay’s forecasts that between US$250 and US$500 billion of hedge fund assets are set to move to equities from other asset classes.”


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