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Assessing US equity valuations

This reflects a relatively cheaper equity market. The current ERP equals the average should we consider only data since the credit crisis (a conservative approach over an era of ultra-low interest rates).

On a similar basis, the free cash flow yield spread with the bond yield is currently half a standard deviation above its average. The dividend yield is more than one standard deviation above its own average.

A novel way to consider equity valuations is to bring price volatility into the equation and assess the level of euphoria or despair in earnings valuations.

Interestingly enough, also on this basis the current valuation is close to its average level, reflecting a disciplined marketplace.

Inflation

The level of inflation is a critical factor in equity valuations, for various reasons.

The current environment of low and stable inflation reduces economic risks with a more certain business outlook, in sharp contrast to the pre-1985 era.

The Alan Greenspan Goldilocks phase of a ‘not too hot, not too cold’ economy with its benefits also comes to mind in this context.

There is a clear historic correlation between inflation and earnings valuation levels, as reflected in the chart.

We are currently in the proverbial ‘sweet spot’ for higher equity valuations in this inflation context. With personal consumption expenditure at 1.6 per cent and consumer price index at 2.0 per cent and a continuing benign outlook, the current 18.8 times price-earnings fits well into both the first two inflation categoriesin the chart.

There is no single good answer to the question of the level of equity valuations. Considering all of the above information, we can, however, make a case that valuations are fair barring an unexpected economic shock. 

Different investors have different approaches in considering their investment activities.

Some look for cheap entry points to increase the probability of fair future returns and are willing to wait for below-average valuations before getting tempted into the market. 

They may put a lower consideration to the economic or business outlook. 

We do not perceive the current market circumstances to offer these investors that many opportunities. 

Against this, others may first consider the quality of the potential investment and the sustainability of its future organic growth potential and then consider its valuation metrics. 

They may have less risk of their businesses disappointing and may be more comfortable with the higher level of valuations we see currently.

Gerrit Smit is head of equity management at Stonehage Fleming