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Stock Slide Brings Valuations Down, Though Some Suggest ‘Proceed with Caution’

One of the bright sides to a stock selloff is that shares become cheaper. But these days it may just be a case of buyer beware if you’re concerned about the risk landscape on the one hand, or an opportunity to do some bargain hunting if you think there’s still room for stocks to rebound on the other hand.

The significant decline in global stock markets during October and continued volatility thus far in November has resulted in valuations across markets hitting their lowest levels in more than two years – based on forward 12-months earnings expectations.

For example, global equities in developed markets, as tracked by the MSCI World Index were trading at 14.1 times forward earnings (the share price divided by one-year forward earnings based on analysts’ estimates) through November 2. That compares with a historical average of 14.3 and down from the 15.55 forward price-to-earnings (P/E) ratio which the MSCI World Index was trading at as recently as the end of September, according to data from BlackRock and Morgan Stanley Capital International.1,2

The recent dip in global equity valuations as tracked by the MSCI World Index below the three-decade historical average hasn’t gone unnoticed. “Whilst it is true that the equity bull market of much of the last decade had gone too far, so too did October’s sharp correction,” Luca Paolini, Pictet Asset Management’s chief strategist, told the FT Advisor in this November 12 report.3

He noted that valuations below their historical average is a shift that’s at odds with the fundamentals. “Although global economic growth and corporate earnings are already rolling over from their peak earlier in the year, history tells us it’s even more damaging to sell out of the last, frothy stage of a bull cycle than it is to sell too late,” Paolini said.

Stocks may still be pricey based on their price-to-book ratio or the cost of a stock compared to the value of the company if it were to be broken up and sold. Based on that ratio, they are currently about 6.0% cheaper than they were from late January when major indexes across the globe were at or near historical highs. However, they are still about 10% pricier than two years ago, prior to the post-election rally, according to a November 12 blog post by Russ Koesterich, portfolio manager for BlackRock’s Global Allocation team.1

Also back in 2016, the yield on the benchmark 10-year Treasury note was about 1.80% while German government bonds (known as bunds) had just crossed above 0%. As of November 13, the 10-year Treasury note was yielding 3.14%, while the 10-year bund’s yield was about 0.41%. “In other words, not only were stocks modestly cheaper on an absolute basis, they were much cheaper once you adjusted for interest rates,” Koesterich wrote.

Shift to Quality

What has also emerged in recent weeks is a focus on quality as a style factor for picking stocks – essentially companies with strong balance sheets, less debt and less reliance on the economy. Some of the more well-known names in the quality basket of stocks have strong brands, sustainable business models and a history of rewarding investors with strong dividends and earnings.

Until recently, these stocks tended to underperform stocks of companies with weak balance sheets. But with at or near record debt and leverage among a growing number of U.S. publicly traded companies, rising interest rates and concerns about how much further the current U.S. expansion will last, investors are beginning to show a preference for quality.

The thinking is that these companies’ stocks are beginning to emerge as market leaders, partly as investors seek a defensive strategy ahead of rougher times for the market.

“Investors need to think about more volatility and a quality bias in portfolios,” Citigroup chief equity strategist Tobias Levkovich said earlier this month in a note to clients cited in this CNBC report. He added that Citi’s leading volatility indicator “suggests a bumpier path for stocks in the next 18 months, while elevated interest rates could require investors to skew portfolios toward names with better-quality balance sheets and stronger debt ratings.”4

 

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Sources:

1 Koesterich, R. (2018, November 12). Why valuation alone won’t save equities. BlackRock Blog. Retrieved from: https://www.blackrockblog.com/2018/11/12/valuation-alone-wont-save-equities/?utm_source=blog&utm_medium=hero&utm_campaign=hero

2 MSCI World Index. (2018, September 28). MSCI.com. Retrieved from: https://www.msci.com/documents/10199/178e6643-6ae6-47b9-82be-e1fc565ededb

3 Thorpe, D. (2018, November 12) October sell-off makes equities cheapest for two years. FT Advisor. Retrieved from: https://www.ftadviser.com/investments/2018/11/12/october-sell-off-makes-equities-cheapest-for-two-years/

4 Santoli, M. (2018, November 12). Investors are flocking to ‘quality’ stocks. Here’s what that means for the market. CNBC. Retrieved from: https://www.cnbc.com/2018/11/12/investors-are-flocking-to-quality-stocks-heres-what-that-means-for-the-market.html

Rates:

10-Year Treasury Note:

https://www.marketwatch.com/investing/bond/tmubmusd10y?countrycode=bx

German 10-Year Government Bond:

https://www.marketwatch.com/investing/bond/tmbmkde-10y?countrycode=bx&mod=MW_story_quote

                                                                                                                                                                 

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