Are valuations really bloated?

Advisors should be wary of definitive conclusions about bloated valuations and predictions of muted future returns.

That’s the view of Mark Raes, head of product at BMO Global Asset Management, who believes it is not always the best strategy to compare market cycles. 

He emphasized that there is more at work than just earnings, like a lower interest-rate environment, which supports a higher P/E because discount rates are higher on future earnings.

He said: “It is difficult to compare across periods on market cycles – you can draw general conclusions that it’s higher – but I don’t think you can look back and say, ‘compared to this period in the market they are highly inflated’ because there are a lot of other things going on at the same time.

“If I think about the market, we have had a longer recovery compared to other market cycles. However, the depth of it has not yet come close to where it’s been in other market cycles. Tenure-wise it’s been a bit long but depth-wise it hasn’t been.”

“That is evident in economic growth terms.  While this economic cycle is longer than the average rebound in the US following a downturn (the current recovery is ~8.5 years in duration versus the average recovery of 5.7 years) the trough-to-peak total GDP recovery in the US pales relative to previous periods (the current recovery is a gain of ~18% in total, real GDP terms versus the average recovery, up ~26%). We are, therefore, not yet at a point where obvious excesses are evident.” 

“Higher valuations, quite simply, are supported by lower interest rates and now we’ve just had the US come out with their tax plan, which validates some of the valuations out there.”

Forecasts of an end to the bull market and warnings of a recession have put advisors and investors on alert. However, Raes believes there is more on the table.

He said: “Investors would have missed some very strong equity returns in 2017 if they had lowered their equity weight or done something else along those lines. To be clear, we are at a point at this mature stage in the cycle where caution is warranted and our Global Multi-Asset Team will be closely monitoring the outlook for the global economy and capital markets for when and how best to de-risk portfolios.”

“Notwithstanding that, we will be staying invested in the equity markets. You can look at certain smart beta approaches to take some of that higher-end risk off the table. I think that’s a great value of smart beta ETFs, but at the same time those broad market exposures, like S&P 500 (ticker: ZSP), they really drove the market in 2017, so I think you still need that in your portfolio because there is still room for growth.”

Raes is backing synchronized global growth with his asset allocation on the equity side, highlighting improvement in Europe, US tax cuts and higher oil prices in Canada.

He added: “I think within types of market exposure, we are exploring certain smart beta strategies, whether it’s a value approach, that’s of course capturing undervalued securities in the market, or a quality approach to make sure we are capturing the right names.”

“In terms of equity or fixed income, we are still favouring equities. We expect rate increases to continue in 2018. I think it will be a measured approach; I think we certainly saw when the Bank of Canada moved early in September last year that that caused a little bit of market unrest and I think the central banks are going to be quite careful about their signals to the market.”

In the ETF sphere, Raes believes the broad markets are a great starting point for investors but said there are options for those eager to de-risk their portfolios.

“Quality ETFs, low-volatility ETFs, those types of products are highly valuable,” Raes said. “Then, if you are concerned about valuation levels, value factor ETFs work quite well that way (tickers: ZVC, ZVU, ZVI). On the fixed-income side, ETFs allow you to have really precise position to complement your core portfolio where you could add something like a short corporate bond (ticker: ZCS) if you are worried about rising rates but still want that yield carry.”

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