Guest column: Are markets overly optimistic?

letko brosseau

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By Wesley Scanterbury and Joel Kaczor

Investment Services – Letko Brosseau

Are markets overly optimistic?

Global equity markets rose to new record highs in Q2 on upward revisions to company earnings and improving economic momentum. The total return of the S&P 500 was 12 per cent year-to-date (in Canadian dollar terms), while the S&P/TSX (17.3 per cent), FTSE 100 (9.2 per cent), DAX (6.9 per cent), MSCI World (9.9%) and MSCI EM (4.4 per cent) all climbed higher during the year.

Broad market highs against a backdrop of rising inflationary pressures and an uneven global economic recovery have led to concerns over whether equities are overvalued.

The S&P 500 Index currently trades at 20.3 times 2022 estimated earnings, 35 per cent above its long-term average of 15x, lending support to the view that valuations have been pushed into rich territory.

However, our analysis shows that a subset of companies are biasing metrics upward. The top 20 per cent highest valuation stocks of the S&P 500 currently trade at an average 70.8 times estimated 2022 earnings while the bottom 20 per cent trade at a modest 10.5 times P/E.

In addition, when considering a broader universe of companies, equities appear to be far from uniformly expensive. The 2022 P/E multiple for the Russell 3000 Index is 21.3, but the Russell 3000 Value Index trades at 16.7 times 2022 earnings while the P/E multiple for the Russell 3000 Growth Index is an elevated 28.9. The presence of large discrepancies in relative valuations across different segments of the market signals both caution and opportunity.

We believe economic fundamentals support an outlook for strong earnings growth. Through the first five months of the year, earnings estimates for 2021-22 were revised higher for nearly 70 per cent of companies in the S&P 500 Index.

As reopening continues, many service-oriented businesses that were disproportionately impacted by the pandemic should realize strong upside potential. Industries such as airlines, airports and malls should benefit from a return to normal.

While equities continue to adjust to strengthening global activity, bond markets do not fully reflect the current reality of higher growth and inflation. At 1.44 per cent, the yield on the 10‑year U.S. government bond is well below the 4 per cent level that is consistent with modest estimates of 2 per cent real GDP growth and 2 per cent inflation.

In Canada, despite a 290-basis-point increase in the inflation rate since the beginning of the year, the 10-year federal government bond yield only increased by 72 basis points. Interest rates could remain low for some time given the accommodative stances of central banks.

However, monetary authorities’ willingness to tolerate higher inflation and governments’ multi-year expansionary policies weigh heavily on the risk/return relationship offered by bonds.

We continue to favour a diversified portfolio of well-valued equities over bonds. Capital preservation and low duration remain the focus of our fixed income strategy.


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