Are equities cheap?

Optimists argue that the current turmoil in credit markets is unlikely to have a lasting impact on equity markets - unless it leads to a serious weakening in global output growth - because equity markets are cheap. Are they right?

The answer to this question very much depends on how we assess equity market valuation. In the 1980s and 1990s the widely accepted method was to compare the yield on equities with the yield on bonds. When bond yields rose, it was argued, that equity yields should rise too. Because this view was supported in a paper written by researchers at the US Federal Reserve, it became widely known as the "Fed model".

The "Fed model" worked because the main focus and fear in financial markets in the 1980s and 1990s was inflation. When inflation increased, central banks reacted by pushing interest rates higher. This led to higher bond yields (and lower prices). Equity yields also tended to rise, and prices to fall, for two reasons. First, some investors saw the rise in bond yields as making them more attractive and so switched assets from equities to bonds. Second, higher interest rates were seen as worsening the outlook for output and profit growth.

Although some strategists still use it, the "Fed model" is no longer seen as the best way to value equity markets. Inflation is no longer the main focus and financial markets are more concerned about the economic cycle. This means that bond and equity yields (and prices) now tend to move in opposite directions. When economic growth is strong, bonds do poorly and equities tend to thrive; when growth is weak, bond returns tend to be good and equity returns poor.

As a result, financial markets now tend to concentrate on absolute measures of valuation for equity markets and a particular favourite is the price/earnings (p/e) ratio, based on where analysts think earnings will be in 12 months time.

On this basis, equities in the United States and Europe (but not in Asia and Latin America) do appear to be cheap. The p/e ratio in the United States has fallen to around 14x - close to its lowest level since 1996. While there is no "correct" value for the p/e ratio, historical analysis suggests that there is a loose relationship between medium-term inflation and equity valuation. When inflation is high or the economy is in deflation, equity markets tend to be cheaper (because investors are demanding a high risk premium to invest). When inflation is low and stable, as it is at present, valuations tend to be relatively high. This analysis would suggest that the p/e ratio ought to be higher than it currently is, and that equity markets are cheap.

But the p/e ratio is only a reliable guide to equity market valuation if the level of earnings on which it is based is sustainable, and that is where the doubts come in. Earnings growth in all the major economies has been very strong in recent years and profit margins have been pushed to multi-year highs. In part, this reflects structural factors: rapid technological change and globalisation both tend to favour companies at the expense of workers, making it easier for them to control costs and boost margins. In part, though, higher margins are due to the cyclical strength of the global economy in recent years, and this may be less sustainable.

Simple analysis suggests that the level of earnings in the United States and Europe could be 20 to 30% above its long-run trend. If this is right, then the "cyclically-adjusted" p/e ratio may be nearer 18x than 14x. This would suggest equity markets are closer to fair value.

For this reason, we feel that it is unlikely that valuation will offer much support to equity markets in the present environment. If the turmoil in credit markets ultimately leads to a significant weakening in output and profits, then equity markets will almost certainly fall further. If the global economy is not impacted, then equities should be able to recover much of their recent losses, though it may take some time for confidence to be fully restored.

Tony Dolphin, Director of Economics and Asset Allocation, Henderson Global Investors