Expensive Valuations Send Mixed Signals

By Robert Serenbetz, Multi-Asset Solutions Team for New York Life Investments

Equity markets have steadily moved higher since January 2019, despite several headwinds. Even as economic and profit growth slow, neither the threat of war nor epidemics, have been able to dampen investor sentiment.

By our calculation, U.S. equity valuations are expensive. And, investors today are willing to pay around $22 for a dollar of corporate earnings — one of the highest prices of this expansion. Perhaps investors are optimistic that the future economic environment will be better than today; over time, accommodative monetary policy and reduced concern about coronavirus or trade wars could result in a real improvement in the economy and lead to a turnaround in corporate profits.

Or perhaps traditional equity valuation metrics no longer apply. For much of this economic expansion, and its accompanying bull market, traditional valuation metrics have not served as a useful signal for fundamental investors. Equity multiples, volatility signals, credit spreads, currency forwards, and risk premia metrics have effectively broken down. Instead of following those fundamentals, the market focuses on interest rates and liquidity conditions.

This valuation disconnect does not have to be feared in its entirety, but it does tend to obscure the valuation process. For instance, lower average interest rates mean that equity multiples can be higher on average and credit spreads lower. However, the disconnect in valuation introduces new risks. Lower rates and lower growth expectations have reduced return assumptions and pushed investors to buy riskier assets despite muted prospects for sustainable profit growth.

Identifying value has become more challenging

For long-term investors, high valuations matter. Very few indicators have much luck predicting investor returns over the short term, but valuations are one of the single best indications for investor expectations over the next decade or so.

As a result, it is appropriate for most investors to focus on portfolio resiliency. There is more than one way to achieve a resilient portfolio. We recommend focusing on a combination of:

1. Relying on more than just “prices going up” to add value: In equities, that means consistent dividend growth from companies with solid cash flows. And in fixed income, that means diligent credit research to avoid defaults. The combination offers a stable driver of long-term returns.
2. Diversifying sources of exposure: Bouts of higher volatility and correlations between asset classes can make it particularly difficult to achieve investment objectives. Investors may benefit from expanding their portfolio into real assets, real estate, and municipal bonds
3. Being creative in your review of valuations. Consider a more selective approach to allocating across risky assets, paying close attention to profits, factors, styles, and geographies.

Bottom line

A typical economic slowdown would favor removing risk exposure, included in equities. High absolute valuations would support that tactic, but relative valuations suggest that risk may still be better rewarded in equities than in corporate credit or government bonds. For the near term, investor sentiment and liquidity will drive markets. Still, today’s valuation levels suggest that downside risk is building.

For most investors, we believe it is appropriate to manage portfolio risk by gradually moving toward a more defensive posture—focusing on generating income across asset classes. Within equities, we like large caps and high-quality companies, as well as international and emerging equities should global growth accelerate in the next six months since they offer more upside potential given their cheaper relative valuations and leverage to international revenues.

Asset Class vs. US Large Cap	Valuations	View
Small Caps	Small caps trade very expensive on absolute and relative basis. (Top decile)	Future profit growth for small caps is extremely optimistic. Heavy debt burden, low profitability levels, and less pricing power make these assets more vulnerable to late cycle dynamics.
International Developed Equity	Cheap on a relative and absolute basis	Differences in sector composition and growth differentials contribute to valuation premia – however a greater weight to cyclical industries could lead to temporary outperformance.
Emerging Market Equity	Neutral valuation	Emerging market company profits poised to rise on any improvement in Chinese growth prospects.
US Aggregate Bonds	Expensive	Investment grade bonds and sovereign debt is very expensive on a historical basis and relative to equity.
High Yield Bonds	Expensive	Despite some spread widening in the riskiest of credits, junk bonds do not reward investor risk.
Leveraged Loans	Expensive	Leveraged loans trade at within top 5% of historical valuation level.