Revaluing shares as inflation clouds gather

The headquarters of the European Central Bank (ECB) in Frankfurt am Main, in Germany. Picture: AFP

In recent months, global equity markets have continued their post-Covid recovery, showing incredible resilience and reaching new nominal highs across developed markets.

There is no doubt now that the risks associated with the pandemic are being pushed into the past; inflation has taken over as the key risk in equity markets.

No wonder there is a debate over valuations, with equity markets at 30 times earrings – specifically, does the earnings part of the PE support their valuation?

A London Business School study calculates the 120-year average annual total return for US equities to be 6.6 per cent. The number is 5.3 per cent per annum for the world equity universe.

The LBS study also addresses the question of why equities earn a premium over bond returns. Four factors are advanced:

● Geometric mean dividend yield net of the risk-free rate;

● Annualised dividend growth;

● Expansion of the price / dividend ratio;

● Real exchange rate (this isn’t as important for Australia but is for LBS because it presents blended world long-run returns in US dollars).

The biggest factor driving equity returns to a premium over bonds is dividend income, specifically dividend reinvestment. LBS illustrates this through its study by pointing out that an investor who put $1 into the US equity market in 1900 would have seen the real, after-inflation capita value rise to $17.90 by the end of 2020. However, had dividends been reinvested, the ending valuation would be $2291.

The second-biggest factor is real dividend growth, though this has been modest. Real dividend growth corresponds strongly with earnings growth. And the best long-term performing markets exhibit the best dividend growth rates.

The third factor is expansion of the price/dividend ratio. Dividend yields have fallen consistently. LBS attributes this as much to the ever-widening range of industries represented on stockmarkets as to falling bond yields. They cite the example that the 1900s equity indices were dominated by railways, whereas today’s indices are far more diversified.

The key point in all this is that inflation also needs to be taken into account.

Alan McFarlane of Edinburgh’s Dundas Partners makes the point that the yield on US 10-year treasuries peaked at 15.6 per cent in 1981 and the PE ratio of the S&P 500 index then was 8.5x.

Today, treasuries yield 1.6 per cent and the S&P 500’s PE ratio is over 30x.

McFarlane suggests that dividend growth for broad indices may fall – but there are plenty of companies with businesses that are surging forward and are capable of sustained, real dividend growth of 5 per cent per annum and more.

In other words, it is a more complicated picture than the current debate around inflation suggests. I believe inflation is likely to rise over the coming months, ­especially as supply shortages and bottlenecks continue to push higher global commodity prices. I see this as transitory or short term, not systemic or long term.

As to the question about whether the market can sustain these valuations, McFarlane adds that he would prefer not to pay 30 times earnings for the average stock, but he wouldn’t pay 10 times for an average stock!

The 30-times earnings ratio doesn’t put him off a fine company with assured prospects – and which can grow earnings and dividends greater than 10 per cent per annum for the next five years.

Equity markets will be supported by corporate earnings strength, but unlike the past 12 months we need to get used to more moderate returns.

As I see it, the big unknown is beyond the short term, at say 12 months out. Covid-19 has revealed to all of us that, unlike previous ­cycles, we don’t know where this is headed.

That means it is about balancing risk and being nimble. It’s about expecting the unexpected and potentially being prepared to jump in a different direction than originally anticipated. 

Will Hamilton is the managing partner of Hamilton Wealth Partners, a Melbourne-based wealth manager.