For many investors, the push into equities has been predicated on the fact that valuations in other asset classes are even higher. But, as Evenlode Income fund manager Ben Peters, points out, while bond yields are indeed very low and relative valuations understandable, absolute valuations remain important.
“Given the aggressive monetary stimulus we are seeing, there is the potential to distort equity valuation judgments by lowering discount rates. We believe that examining absolute valuation is particularly important at present to guard against valuation risk.”
As Portfolio Adviser has said before, when valuing equities in such an environment, it is important not only to take account of the lowered discount rate but also the future growth prospects of the company. Yes, it is true that if one lowers the discount rate, assuming everything else is equal, the value of the share goes up. But, it is clear that growth is likely to remain low, which means revenue growth is unlikely to remain robust for everyone.
For Peters, the fact that the market equity risk premium has been allowed to widen to near historic highs, means that “there is sufficient absolute value around to enable us to put together a portfolio with enough potential return to warrant continued long-term investment. Certainly, some stocks have undoubtedly benefitted from being dragged up in price by low bond yields, but we are still uncovering compelling opportunities.”
Dispersion
This goes to the final point about the current rally, while the overall market is at record highs, the level of dispersion within the market is also exceptionally high, which makes it all the more important to consider exactly which stocks you are holding.
David Taylor, manager of the Chelverton UK Equity Income Fund agrees that there remain opportunities in the market, but said in this kind of environment it does not pay to put all one’s eggs in the same basket.
“The small and mid-cap end of the market was definitely oversold heading into Brexit and just afterwards. But, many of the initial risks didn’t materialise and the economic data has continued to improve and so there has been a re-rating,” he said.
But, he added: “Over the next 12 months it is likely that if the data continues to improve mid-caps will do well, but equally when there are pinch points, investors will head for the megacaps. Given the uncertainty at the moment, you have to have a bit of everything.”
It is impossible to know for certain whether or not the FTSE has peaked; there are indications that economic data is improving, but equally it is likely to remain below historic rates for some time to come.
Likewise there have been some significant reratings in certain areas of the market, in particular the mining sector, but others, like banking remain subdued. And, as always there remain a number of macro factors of which one has to take account. All in all, if the market does continue to climb from here, it will do so via a wall of rather large worries. But, so far, that does not seem to have impeded it.
