Are Equity Markets Overvalued?

HIGHLIGHTS

• The MSCI AC World Index is only 2% below the February peak. With expectations of COVID vaccines in coming months, we may not see a meaningful correction in equity market until this good news is realized.
• A tech bubble déjà vu? The robust fundamentals explain US mega-cap tech stocks’ superior returns and higher multiples. With growing evidence on COVID vaccine development and the rebound in economic activity, we could see a rotation from the expensive growth stocks to value stocks.
• Vaccine development, robust liquidity and improving earnings are the positive catalysts for the equity market. However, COVID, US elections, geopolitical tensions remain the key risks We continue to recommend a “barbell” strategy.

Global equities are only a tad below the February record high

The MSCI AC World Index is currently merely 2% below the peak reached in February this year before the Covid-19 crisis. There was a consolidation in June but it continued its rally in July. Many investors have started to worry about whether valuations have become stretched and stock markets are vulnerable. Here we try to address some frequently asked questions regarding the stock markets. 

Potential upside surprise from the vaccine development?

Out of over 250 vaccine candidates globally, 25 of them have entered human clinical trials and 5 of them with promising results in Phase I and II trials have announced timelines for potential emergency use from September to December this year, according to a research report from McKinsey. Experts agreed that COVID-19 vaccines is likely to be available for use in specific populations between 4Q 2020 and 1Q 2021. Thanks to unprecedented access to funding and more advanced technology platforms, the robust vaccine pipeline reveals accelerated development efforts (historically it took at least 4 years to develop a vaccine). Historical attrition rates would also suggest that such a pipeline could yield more than 7 approved products in the next few years. Vaccine manufacturers have announced cumulative capacity that could produce as many as 1 billion doses by end-2020 and 9 billion doses by end-2021 (sufficient for the whole world with 7.8 billion population).

When there are more signs of a potential success in a COVID vaccine, analysts are likely to revise up further their economic growth and corporate earnings forecasts. With hopes and expectations of COVID vaccines in coming months, equity market could remain resilient and we may not see a meaningful correction until this good news is realized (i.e. vaccine is successfully developed – “buy the rumors, sell the news” ). 

A tech bubble déjà vu?

The Big 5 (Apple, Microsoft, Amazon, Alphabet, Facebook*) in the S&P 500 (by index weighting) gained 58% versus only 1% return for the rest of the S&P 500 over the past 12 months. No doubt stock concentration of the Big 5 has driven up the index’s overall forward PE valuation to 22x, almost reaching the peak of 25x in March 2000 before the burst of the tech bubble. Are high valuations justified? Shall we concern about a tech bubble déjà vu?

Compared to the top 5 companies during the tech bubble in 2000 (forward PE 47x), the Big 5 today, which are currently trading on 34x, are not overly stretched. Net margin of Big 5 is 18%, higher than the top 5 companies’ 11% in 2000.  Also, the Big 5 are in net cash position, versus the top 5 companies’ 2% net debt-to-EBITDA during the period of tech bubble.

The Big 5 today in comparison with the rest of S&P 500 are superior in different (trailing 12-month) financial metrics as shown in the table. The gap of sales growth between Big 5 and the broader market is large by historical standards. They also have healthy balance sheets with positive net cash positions (negative net debt-to-EBITDA).

For 2Q, earnings per share (EPS) for the Big 5 grew 19% vs -34% for the broad index. The mega caps have shown their capacity to deliver robust earnings growth at a time when the rest of the market is reeling from the negative impact of COVID-19. In terms of return on equity, US tech in general stands close to 30%, which is significantly higher than other regions in the world (23%).

The robust fundamentals explain US mega-cap tech stocks’ superior returns and higher multiples. The performance and valuation gap could widen further as they are among the major beneficiaries from a low yield environment with secular growth trend from a number of accelerating themes such as 5G, AI and Cloud usage. Nevertheless, the results of US election could affect their performance, especially a Democratic sweep would see risks of tax increase and technology regulation.

Abundant liquidity supports elevated valuations?

The ultra-loose monetary policy and vast excess liquidity do support higher valuations, but they also need to be justified by good earnings in the longer term. For 2Q’s earnings results, US and European companies exceeded consensus EPS forecasts by +22.3% and +7.4% respectively. Hence, 2020 earnings estimates have been adjusted higher in most sectors in the US with forecasts having improved the most in the discretionary and health care sectors. Further opening of economies, continued dovish monetary policy, additional fiscal stimulus and more potential positive newsflows on COVID vaccines could see earnings forecasts for 2020 and 2021 revised up further, and potentially more reasonable PE multiples (with earnings - the denominator of P/E ratio - going up).

Can the stock market momentum sustain after a 48% rally in 5 months? The table shows the 1-month, 3-month, 6-month and 12-month performance of S&P 500 historically after the index had its largest 50-day rally. The results seem to suggest that past big rallies have led to continued strength in the US equity market.

With growing evidence on COVID vaccine development and the rebound in economic activity, we could see a rotation from the expensive growth stocks to value stocks. Value stocks outperformed in 2003 and 2009 during the recovery from their respective recessions. Rotation into value could see the rally to last longer.

To conclude, vaccine development, robust liquidity and improving earnings are the positive catalysts for the equity market. However, at the same time, COVID, US elections, geopolitical tensions remain the key risks that investors can’t simply ignore. Hence, we continue to recommend a “barbell” strategy – to stay invested with exposure to risk assets and buy on dips on one hand, and to hedge with defensive strategies such as gold, dividend stocks and quality corporate bonds on the other hand.

CIO INSIGHTS - GDP & CPI FORECASTS

GROWTH

• We have upgraded the 2020 GDP growth forecast for the US to -4.9% from -6.6%, reflecting the recent better-than-expected data. We cut growth forecasts for India and several Southeast Asian countries due to wider spread of Covid-19. For China, we continue to forecast 2.5% growth for this year.
• In Europe, the deal reached on the EU recovery fund represents a decisive step forward in the EU policy framework and means both monetary and fiscal policy are providing a tailwind to the economic recovery.

INFLATION

• Our inflation forecasts have been revised down in general. We continue to expect a gradual economic recovery as policy measures take effect. Our base case is still for a 2H recovery for majority of the economies. Thus, we expect demand to return and inflation to pick up in the second half of the year and into 2021. Nonetheless, inflation will likely still remain weak for the whole 2020 given the drastic drop in demand due to the pandemic.
• For the US, we expect inflation to be 0.8% for 2020 before rebounding back to 1.5% for 2021, while for Japan, we expect deflation for both years (-0.3% for 2020 and -0.7 for 2021).

CIO INSIGHTS - EQUITIES

• Global equities have risen 48% since their March low, bringing them just 2% away from their February record high. EM/Asian equities outperformed in July, thanks to the USD weakness. Valuations, in particular for US markets, are elevated but are supported by high level of excess liquidity and better-than-expected earnings results.
• For 2Q’s earnings results, US and European companies exceeded consensus EPS forecasts by +22.3% and +7.4% respectively. Hence, 2020 earnings estimates have been adjusted higher in most sectors in the US with forecasts having improved the most in the discretionary and health care sectors.
• Vaccine development, robust liquidity and improving earnings are the positive catalysts for the equity market. However, we expect volatility to increase over coming months due to concerns over key risk such as COVID, the US presidential election and geopolitical threats.

CIO INSIGHTS - FIXED INCOME

• The Fed’s July meeting seems to pave way for the potential changes in the September meeting. We expect to see their shift to average inflation targeting, which would allow for higher than 2% inflation (overshoot) for a period of time to compensate for past misses (undershoot). They are also likely   to change forward guidance from forecast-based (inflation forecasts) to outcome-based (realized inflation). All this would imply that the Fed would be committed to refrain from raising rates until realized average inflation is at target.
• Credit market in general did well in July with US high yield, Asia and EM USD bonds outperforming. We keep our positive stance on Hong Kong and Singapore credit. For China credit, valuations are not cheap, but liquidity is abundant and supply is manageable. As fundamentals have weakened, we would advocate to be selective and to stick with short to medium duration from quality names and laggards for Chinese High Yield property.
• The commitment of the Fed to keep rates low and the weakness in USD are both beneficial for the EM/Asia asset classes. Despite positive medium-term outlook amid continued economic recovery, we prefer to stay neutral on EM HC bonds as some consolidation may be expected in the short-term after the strong rebound.

CIO INSIGHTS - FOREX

USD: The broad dollar index (DXY) fell significantly from 97 to 93 in July, due to a spike of infections cases in the US and the European agreement on the Recovery Fund (EUR accounts for 57% of the USD Index). We expect the USD Index to see some consolidation in the short term before resuming its downward trend.

EUR: The past month was supportive for the euro with EURUSD rising to 1.19. Macro releases confirmed the resumption in activity and the better consumer sentiment. More importantly, the breakthrough on the European joint fiscal action strongly supported the euro which broke our 12-month target of 1.17. However, the recent appreciation of the euro seems overdone in the near term. The technical indicators also suggest an overbought situation for the euro.  We expect a temporary consolidation in the short term.

CIO INSIGHTS - ALTERNATIVES & COMMODITIES

COMMODITIES

GOLD: Gold surged to the fresh record high of $2071 in early August and then later dropped to the low of $1867. After gold hitting our upper target of $2050,  we have raised the target range to USD 1900 – 2100. We remain positive on gold, and any pullbacks are buying opportunities. The current ultra-accommodative monetary policy is expected to last for a while,  and real bond yields should remain negative or very low for longer. Massive quantitative easing is also scaring some investors, increasing the attractiveness of gold as a hedge.

OIL: Oil prices have stabilized as lockdown measures and travel restrictions worldwide are slowly being lifted. Supply side is also looking better with lower US inventories and efforts by OPEC+ to continue its production cut. The combination of a rebound in global demand and a fall in supply should help the price of Brent recover towards $45-55/b in the second half of 2020.

ALTERNATIVES

LONG-SHORT EQUITIES: We are positive on long-short equities. The indiscriminate sell-off gave managers a chance to buy high quality businesses at a discount, with strong recovery potential.  The crisis will no doubt create survivors and losers, offering  attractive long/short opportunities for fundamental stock pickers. Short restrictions in continental Europe have been lifted. We remain cautious on quantitative market neutral managers, as they are less likely to correctly adapt to the new post crisis market paradigm, even if a lot of assets have now left those strategies.

GLOBAL MACRO: We are positive on macro managers. After Central Banks and governments have injected the most liquidity ever in exchange for hugely increased debt, FX and fixed income markets are bound to offer trading opportunities. Increasing deglobalization and differentiated country fiscal policy should offer more relative value opportunities. CTAs have a role to play in portfolios, as tail hedge in case of a lasting bear market.  But they are also subject to reversals in the current fast changing environment.

Source: BNP Paribas Wealth Management as of 14 August 2020

*For illustration only and not represent any investment recommendation.

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