Richard Cayne at Meyer International Ltd comments that Government bonds while being very overvalued and while financial theory usually stipulates that measures of valuation begin with the “risk free rate” on a long-term US Treasury bond. This risk-free rate is usually used as a starting point when calculating the expected return on dollar-denominated equities.
In her testimony to the Senate Banking Committee, Janet Yellen used the equity risk premium – that is, the valuation of equities relative to government bonds – to explain why there is no bubble in stock prices.
But with base interest rates at record low levels, and with QE helping to push down long-term bond yields, one could argue that government bonds themselves are highly overvalued. Prices have declined this year, but 10-year yields remain just 1 percentage point from their all-time lows which is quite low and not likely to stay at these levels for a long time says Richard Cayne Meyer.
Therefore, while the equity risk premium helps us understand the relative attractiveness of equities, it doesn’t necessarily prove there is no bubble. It could merely show that equities are in a smaller bubble than government bonds are.
Richard Cayne Meyer comments that equity valuations appear to be fair to slightly high, excluding those measures of equity valuation that involve the risk-free rate, we are effectively left with comparing price-to-earnings (P/E) or price-to-book multiples relative to historical levels.
Regionally, the largest two global markets trade in line with long-run averages. US stocks trade at 16.5x their trailing earnings versus their 25-year average of 16.9x, and the Eurozone trades at 14.8x versus its 25-year average of 14.7x. Emerging markets trade at 11.7x, or a 23% discount.
But with global net profit margins higher than average, and with corporate profits as a percentage of GDP at record highs, one could argue that the earnings themselves are in a bubble. However, this is likely not the case explains Richard Cayne Meyer.
The figures can be explained by two secular trends. The declining cost of capital has enabled companies to materially lower interest costs for the foreseeable future, and globalization has opened up new earnings streams as well as enabling diversification into lower tax jurisdictions.
Cash – awaiting inflation with equities trading at or above long-run average valuations and bonds far above them, cash is coming back into favor among some investors. A curious feature of the recent
Bank of America Merrill Lynch (BofA) fund manager survey was that cash balances are, at 4.6%, unusually high given the recent strong performance of equity markets.
Richard Cayne goes on to explain how valuations of equities and high yield credit are not at levels likely to cause mean reversion to detract from returns. Earnings growth and low default rates should support positive returns in both asset classes, which remain more attractive than cash and far more compelling than government bonds, whose real returns are likely to be negative.
Nonetheless, investors should not expect a repeat of the financial asset performance seen in the past five years, especially as monetary policy normalizes in the years ahead. And in a world of lower returns, higher rates of inflation could further cut into them. Investors will need to seek alternative sources of return, including private markets, and take a more tactical approach to asset allocation comments Richard Cayne at Meyer International Bangkok Thailand.
Richard Cayne Meyer a native of Montreal, Quebec Canada currently resides in Bangkok Thailand and runs the Meyer Group of Companies. Prior to which he was residing in Tokyo Japan for over 15 years and is currently CEO of Asia Wealth Group Holdings Ltd a London, UK Stock Exchange listed Financial Holdings Company.