Are the valuations too high in the stock markets?

Are the valuations too high in the stock markets?

What happens in the stock markets. The comment by Roberto Rossignoli, Portfolio Manager of Moneyfarm

The last month was characterized by high volatility on the main price lists, although it was partially reabsorbed compared to the most acute moments of the crisis (Vix at around 30.4). The market trend, characterized by several weeks of continuous and constant growth of the share sandwiched by rapid corrections, reflects what are the main factors that are driving the markets. It should be noted that the quarter that has just ended has been the best for American equities since 1987. Such a performance requires reflection on what the path could be in the coming months.


The lists are driven by better than expected economic data, which leaves room for the positive run-up of the stock market. In the background, however, risks remain and a scenario that remains rather uncertain, especially due to the health emergency, in many geographies less under control than it should have been at this point.

But let's go in order: the past few weeks have been characterized by a series of positive data, both from a macro data point of view and as regards the confidence of the operators. The economic surprise index published by Bank of America marked a positive record. This means that the news coming from the real economy, however negative, was however less negative than expected in the quarantine quarter.

Investors' forecast is that positive macroeconomic data will be transmitted on the results of companies, data that will be published in the coming weeks. A earnings season that surprises expectations would make equity valuations more sustainable.

The relative price of the stock markets, calculated as the cost of the shares in relation to the profits generated by the companies, remains in fact one of the big question marks of this phase. If we were to limit ourselves to a single evaluation of the Price / Earnings indicator we would find that at this moment it is positioned quite high compared to the story.

In reality this figure is not relevant on its own, but must be assessed in context. First of all, as we have already mentioned, there is the positive effect that could result from the publication of the half-year results of the companies in the event of a positive surprise. Secondly, the level of interest rates must be considered in the equation. When rates are as low as now, even such high valuations become more sustainable. Why?

  • Equity risk premium: low levels of profitability on the bond push investors towards riskier asset classes, even at the cost of accepting a lower level of expected volatility.
    Future profits are discounted at a lower rate, the present value of those profits – or the fundamental price – goes up, and consequently the price / earnings ratio, but also the other valuation metrics, go up.
    From a macroeconomic point of view, it can be assumed that a generally lower cost of capital favors the business world, in particular those with high growth potential that are able to invest with higher yield prospects.
    Still from a macro point of view, the relationship between rates and inflation is interesting. Low and low volatility rates also reflect low and controlled inflation. And that's good for equities.

In short, low rates and an economic scenario in recovery also make the high valuations that characterize this phase less anomalous and we believe that, despite the run of the last few weeks, equities still have the possibility of growing, even in the medium-term.


The graph shows the distribution of the P / E level, conditioned (that is, consistent) with the level of interest rates. It shows that on average there is a negative relationship between interest rates and valuations. As you can see, even if the Median level (dark blue line) predicted by the linear relationship between rates and valuations (red line) was not necessarily an effective indicator, historically the valuations have moved within the range "determined" by this relationship, effectively identifying periods of high or low assessments.

Obviously the condition for this to happen is a progressive resolution of the health emergency. The data of the last few weeks is not encouraging, especially in the United States and South America, but one should not make the mistake of dramatizing them excessively. In general, even in the event of a re-emergence of the contagions, the level of preparedness of the governments would certainly be higher than a few months ago and this gives us confidence to continue to gradually reposition our allocations towards the medium-long term profitability and volatility objectives term.

This is a machine translation from Italian language of a post published on Start Magazine at the URL on Sun, 12 Jul 2020 05:00:08 +0000.