Few analysts disagree that the opportunity for extraordinary long run returns has closed.
Three years ago equity risk premiums – a function of the compensation investors are willing to accept for the risk of companies’ future earnings – were extremely high.
Today they have come down closer towards the pre-crisis norm. As we have discussed at length before, this is in part due to quantitative easing forcing investors to accept a much lower compensation for equity risk as they sought an acceptable rate of return.
However, it is also about investors becoming more realistic about the prospect of future earnings.
If the value of a company with zero growth potential is calculated by projecting today’s earnings into perpetuity, the difference between today’s market price and the value of that zero-growth perpetuity is arguably the ‘present value of future growth opportunities’.
Markets are valuing growth opportunities in a manner more consistent with previous convention.
In short, without a powerful catalyst (and we do not believe there is one on the horizon) there is little room for valuations to continue their march higher.
Instead, rather than continue to pay more for the same level of earnings, investors will look to earnings growth to drive returns – a key characteristic of an aging bull market.
In this aging bull market, equity investors must become more selective. A greater dispersion of price momentum among industry sectors is also a key characteristic, and we can see that happening today.
There has been little correlation between valuation metrics and price momentum during the year to date and cyclical sectors are treading water against defensive sectors. Using the Triangle rankings within Canaccord Quest, we actually observe a mildly negative relationship between those sectors scoring well on value and those with strong momentum (price) scores.
The recent decrease in dispersion is more about a correction in some of the markets that have delivered extraordinary gains in the past 12 months (for example, biotech, software, retail and personal goods).
We view this as a healthy de-frothing. Many of those companies that needed a de-frothing have actually done well in the past six months for a reason – earnings and growth (actual and forecast).
Our econometric model for broad market earnings growth (based on wage, input and interest expenses as well as the economic outlook) suggests stocks in aggregate are unlikely to deliver growth stronger than mid-high single digits in the next year or so, and even this requires global macroeconomic improvement towards the end of 2014.
Although this is a little lower than the aggregate forecast from bottom-up equity research analysts, it is perhaps rather more consistent with the current trend of companies revising down their own guidance for earnings growth.
This reinforces the view that, if earnings are difficult to come by, companies will continue to turn to mergers and acquisitions to drive returns and we continue to emphasise that positioning for earnings growth is the key to outperformance here.