Why equity investing has become a ‘balancing act’

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June 01 2017
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The rally in equity markets has been running for close to a decade, prompting fears it can’t last much longer, but with economic conditions starting to pick up, some opportunities remain, according to investment firm Natixis Global Asset Management.

Equities have rallied since the market bottomed in March 2009, and while many contend that these rallies “don’t die of old age”, Natixis’ chief market strategist David Lafferty says the symptoms associated with their age may be enough to bring them to an end.

“Economic recovery/expansion can’t last indefinitely,” he cautioned.

What investors should take note of, however, is that economies around the world are gaining momentum on many of the metrics used to assess their performance, Mr Lafferty said.

“For the first time in more than ten years, the global economy might be experiencing something close to a synchronised expansion. According to Bloomberg data, over the next three years, the compound annual earnings growth rate for global equities is 9.7 per cent,” he said.

“This is a fairly strong global earnings outlook and an unlikely environment for the emergence of a bear market.”

That’s not to say global markets aren’t without their challenges at present, and Mr Lafferty pointed to systemic risks within China and the possibility of a cyclical slowdown as examples. He added that “risk always seems to come out of nowhere”, but overall these were not major problems for most investors.

“Yes, investors should expect markets to get more volatile, but that vague notion alone isn’t sufficient reason to abandon equities, especially when historical probabilities are stacked against [those who say otherwise],” he said.

“Being outright bearish requires a compelling reason, which we don’t see today.”

To further confuse the situation, Mr Lafferty explained that while the evidence for falls in share prices is scarce, the prices are too high.

“While stocks haven’t reached nosebleed valuations, they are elevated in almost every market,” he said.

“Within an asset allocation framework, elevated valuations imply both lower expected returns and greater downside volatility. Expensive stocks have further to fall than cheap stocks due to their slimmer ‘margin of safety’.

“Investors should be cautious on equities not because stocks are likely to go down, but simply because the return per unit of risk deteriorates as valuations become extended.”

What does this mean for equity investors? According to Mr Lafferty, it means “positive but subpar” returns moving forward.

“The outlook for equities is a balancing act between improving fundamentals and elevated valuations. At current levels, investors should expect little in the way of price to earnings ratio expansion,” he said.

“However, in the absence of significantly higher inflation and/or much tighter monetary policy – two factors that typically pressure stock valuations – price to earnings ratios can remain elevated for some time.”

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