To what extent do share valuation trends reflect the rises and fall of economies and countries? That is the question that occurs when reading a report from Morgan Stanley’s Gerard Minack on long term trends. It says that the last 30 years were exceptional for shares:
The past 30 years were exceptional, for a number of reasons, so I think will be a poor guide to what happens over the next decade. One unusual aspect was the valuation of risk assets – notably the valuation of equities. Equities look cheap based on the past 25 years; based on pre-1980 valuations, they are not. Adam Parker, our US strategist, believes the PE for US equities could fall to 10 times over the medium term.
The period since 1980 was very unusual for developed economies. The highlights are well known: sustained, benign decline in inflation; generally declining real interest rates; and trend increase in leverage. There were also major, largely investor-friendly, surprises: the Cold War ending; widespread economic and financial deregulation; globalization broadened and deepened; and IT become ubiquitous.
This is a pretty good starting list, but I would go further. There is a general running down happening in developed industrial societies. They are not coming up with the new products that are needed to stimulate growth. About 80% of “new” products are refinements of old products. A kind of exhausation is setting in, masked by two things. One was the “financialisation” of Western economies, which was for the most part a debt driven inflation of existing assets, ending in tears for the most part. Little went into productive investment because there were too few ideas about new things to produce.
The second thing was the industrialisation of China, India and the rest fo the developing world. This has covered up the exhaustion occurring in Western economies.
The report says that by some measures equities are cheap, by others, not. Rather than using historical norms to assess value, I would think a better question to ask is can equities thrive by serving the emerging economies? Because they are certainly not going to be serving developed economies.
The higher valuation of equities is difficult to justify by a fundamental improvement in equities as an asset class. In particular, equities did not participate in the so-called ‘great moderation’ in many macro variables – the fall in volatility over the 25 years after 1983. The reverse happened: equity earnings have become more volatile, based on reported earnings or the macro measure of earnings (Exhibit 2). Likewise, the variability of US equity returns (a rolling 5 year window of 12 month returns) is now at its highest level since the 1940s.
Well worth a read.