Fisher Investments UK on Today’s Allegedly Expensive Equities

Global markets have recovered considerably since their year-to-date lowpoint in late March, and as we write, they are a little bit above their pre-COVID lockdown highs.ⁱ Yet the MSCI World Index’s price-to-earnings ratio—which attempts to measure whether share prices are too expensive relative to corporate earnings—is at its highest level in nearly 20 years.ⁱⁱ This and other high valuation metrics have prompted many financial commentators we follow to warn that shares have risen too far, too fast since late March—setting up another big decline. As we will explain, Fisher Investments UK’s research indicates this theory suffers a number of flaws.

There are two main types of price-to-earnings ratio, also known as a PE. Both divide equity prices by a measure of earnings. Why? When you own equities, you own a share of the firms’ future profitability. Given this, share price alone cannot tell you if a stock is cheap or expensive. You must gauge how much you are paying in price for each pound in earnings. PEs are an effort to do exactly that.

The first type of PE, called the trailing PE, divides share price by the past year’s worth of earnings. The second, called the forward PE, divides price by analysts’ estimated earnings over the next year. Some commentators consider the trailing PE more useful since it uses actual results, not analysts’ estimates—which may be little more than educated guesses, given 2020’s unprecedented economic contraction—and rebound. Others prefer the forward PE since, if you accept that markets are forward-looking (which the vast majority of the investment universe does, according to our read of financial literature), then the trailing PE is old news and likely already reflected in share prices. Yet adherents of either PE see plenty to dislike right now. As we write, the MSCI World Index’s trailing PE is 23.3, the highest since December 2001.ⁱⁱⁱ Its forward PE hit 21.2 in August, the highest since April 2001.^iv Either measure, using the conventional logic, supposedly signals global shares are too expensive.

In Fisher Investments UK’s experience, however, PE ratios aren’t especially useful in forecasting. Especially so in the aftermath of a bear market. Bear markets are gruelling market declines of -20% or worse with identifiable fundamental causes, and throughout market history, they have usually accompanied economic recessions (meaning, broad declines in economic activity). Recessions usually cause corporate earnings to decline considerably. Yet equity bear markets usually end before the recessions do.^v That means a new bull market—a prolonged period of generally rising equity markets—usually begins when earnings are still depressed.^vi In several instances, earnings have remained negative for the first few calendar quarters of a bull market.^vii

When share prices rise whilst earnings are still negative, it inflates PE ratios. This is just simple math: A higher numerator divided by a lower denominator yields a higher ratio. Trailing PEs are most susceptible to this, in our view, because they don’t incorporate the expected earnings recovery. But forward PE’s are also vulnerable, as today’s data illustrate. We think this is because few expect earnings to recover instantaneously. Rather, earnings expectations (like those we use which are rounded up by data provider FactSet) are for a more modest recovery off of an extremely depressed base.

Fisher Investments UK’s research indicates it is therefore normal for PE ratios to spike early in a bull market before the earnings recovery helps them stabilise at lower levels. In our view, those commentators who don’t incorporate this trend into their analysis err by focusing on the numerator—share prices—without considering trends in earnings and whether those are temporary. Ask yourself: Are shares really overvalued today if prices are merely anticipating a recovery in earnings over the next few years? Might markets instead be behaving as we think they usually do—as a leading indicator?

PE ratios aren’t wholly useless, in our view. At times, we think they can be a valuable indicator of sentiment, particularly if they spike to extreme levels late in a bull market. In that case, they can indicate investors are too euphoric and not paying sufficient heed to the risk of recession. But early in a bull market, in our view, apparent extremes usually just result from calculation quirks, and we recommend investors seeking long-term growth not read much into them.