Key Takeaways
- Take economic forecasts with a grain of salt. They are often well-intended but can skew your view of investing.
- Try to see the markets upside down. This helps avoid short-term thinking and puts the focus on valuations.
- Historical comparisons are not a silver bullet, however can be useful in thinking probabilistically. On most valuation measures, the global equity market still appears on the expensive side.
- To reap the long-term rewards, we should try to resist getting scared out of an investment, instead positioning portfolios with valuation risks top of mind.
Few investors had the foresight in March 2009 to predict where we would be today after a nine-plus-year bull market. In fact, if you knew in 2009 what lay ahead, your level of disbelief may have been as strong as if someone told you in September 2017 that the market would soon lose half its value before turning around. This has many inherent lessons, but none more than the avoidance of short-term thinking and the power of starting valuations.
Lesson from the Decade Since the Crisis
Let’s rewind to March 2007 momentarily. This was considered to be a goldilocks period as the world looked as healthy as ever—although, as we now know, this assessment of economic health was grossly inaccurate. A false sense of prosperity can be illustrated in a myriad of ways, however one of the more compelling is to reflect on the March 2007 Monthly Bulletin from the European Central Bank (ECB)1. We have highlighted the key statements in bold:
Looking ahead, the medium-term outlook for economic activity remains favourable. The conditions are in place for the euro area economy to grow solidly. As regards the external environment, global economic growth has become more balanced across regions and, while moderating somewhat, remains robust, supported in part by lower oil prices. External conditions thus provide support for euro area exports. Domestic demand in the euro area is also expected to maintain its relatively strong momentum. Investment should remain dynamic, benefiting from an extended period of very favourable financing conditions, balance sheet restructuring, accumulated and ongoing strong corporate earnings, and gains in business efficiency. Consumption should also strengthen further over time, in line with developments in real disposable income, as employment conditions continue to improve.
Does this sound slightly familiar? We are not picking on the ECB—it was just one of many groups whose experts seemingly fell into the trap of the availability bias. The notion that we place too much emphasis on short-term trends is unequivocally important because it is one of the most common and recurring traits that cause financial market cyclicality. If you are not already cynical of short-term projections, maybe the ECB bulletin from the bottom of the market (February 2009) will also help:
The uncertainty surrounding the global economic outlook is exceptionally high, especially as financial market volatility has soared. Overall, the risks for growth are clearly on the downside. They relate mainly to the potential for the turmoil in the financial markets to have a more significant impact on the real economy. The depth and duration of the global economic downturn will depend crucially on the speed at which the financial crisis can be resolved. Other risks relate to concerns about the emergence and intensification of protectionist pressures and to possible disorderly developments owing to global imbalances.
Practically, this means being circumspect about what information we consume and how we consume it. It reinforces both the danger of paying attention to short term economic/market noise and the importance of being independently minded. It also highlights the benefits of viewing the world upside down.
The Power of Starting Valuations
Another lesson from the financial crisis is the power of starting valuations. To help illustrate this concept, on this occasion we ask readers to consider three valuation points: September 2007 (circa market peak), February 2009 (circa market trough) and again today.
Exhibit 1 The principle of buying low and selling high is evident in hindsight, the question is whether today marks a ‘high’ point or a ‘low’ point. See glossary for an explanation of each metric.
|
| Global Equity Valuation Metrics (includes developed & emerging markets) |
30th Sep 2007 |
27th Feb 2009 |
31st Oct 2018 |
| Price/Earnings Ratio |
16.32 |
9.37 |
17.06 |
| Cyclically-Adjusted Price/Earnings Ratio |
26.66 |
12.27 |
21.54 |
| Profit Margins |
9.32% |
7.04% |
8.80% |
| Dividend Yield |
2.18% |
4.33% |
2.58% |
| Return on Equity |
16.10% |
13.31% |
12.84% |
Source: Morningstar Investment Management Calculation, Morningstar Direct at 31 October 2018
We can see from Exhibit 1 that—on most valuation measures—the market is still closer to the 2007 peak valuation levels than the 2009 trough. Of course, the future carries a lot of uncertainty, yet can help an investor to think probabilistically.
The key here is to resist being scared out of an investment and instead position portfolios in a way that acknowledges valuations. When building portfolios, it is important that our investment team study market valuations and consider any dangers overvaluation may present.
Final Thoughts
If an investor can grasp these three concepts—avoiding predictions, thinking probabilistically and acknowledging valuations—they are arguably well on their way to achieving their financial goals.
Tying this together, here are a few other tips we think are relevant at moments like today:
- Remember that investing is best done as a long-term pursuit. The journey will inevitably have ups and downs, however staying the course should prove a fruitful experience.
- There are no silver bullets. By investing in a portfolio that is positioned for multiple outcomes, not just one, you can increase the chances of reaching your goals.
- True risk usually comes from the things we can’t see in front of us. The risks that are openly discussed in the media tend to be priced in by the market quite efficiently.
Similarly, our investment professionals continue to look at risk and return under a valuation lens, seeking to capture the long-term benefits of investing while keeping capital preservation firmly in mind.
