The chart below comes to us courtesy of Bank of America Merrill Lynch. I had initially hoped to show it with just a couple of paragraphs of explanatory text but the more I studied it, the more I found myself drawn into its story. I have attempted to articulate below (and you can click on the chart for an narrated presentation), why I think this chart is so fascinating in as simple terms as possible. This will take some explanation so please bear with me.
The chart shows the 12 month rate of change in the MSCI AC World Index since 1992 in terms of capital return. This capital return is broken down into two constituent parts: changes in earnings; and changes in the market “rating” or valuation (total return also has a third constituent part – reinvested income – but the chart would look even more complicated if we showed that as well!).
The red area shows the contribution to return from earnings growth, the grey area shows the contribution to return from the change in the market rating. If one area is rising and the other is falling, this suggests a period during which the market is moving broadly sideways.
When the red area is dominating the area above zero, it suggests global equities have performed well as a result of earnings growth, a reasonably healthy form of stock market rally. When the grey area is above zero, it suggests that global equities have performed well as a result of a re-rating – in other words the market has become more expensive. This is a more dangerous form of stock market rally.
Let’s now walk through the interesting features of this chart over time.
A mixed picture, but broadly, this was the start of a positive period for global equity markets, with the market first rising in anticipation of an earnings recovery which ultimately arrived in late 1993.
As earnings growth picked up, the market valuation retreated briefly (grey area below zero in 1994/95) before starting to rise again from 1996. This was a period of robust and reasonably healthy performance for global equity markets, driven predominantly by earnings growth but underpinned by a gradual increase in valuation.
Now we move into a classic “late-stage bull market” phase, with earnings growth faltering but global stock markets continued to rise by virtue of a sustained re-rating. In other words, the market’s valuation was becoming more expensive.
This was a period of stock market history during which global equities became driven by sentiment, not by fundamentals. It was the start of the dotcom bubble which drove markets into dangerously expensive territory.
Those of you who have followed Neil Woodford’s career will know that this was a difficult period for the relative performance of his funds. As a fund manager whose investment decisions are anchored in fundamental valuation judgements, this is understandable – he did not participate in the bubble, because he was convinced that the valuations of the shares that were driving the market higher at that time, were unsustainable.
Neil was ultimately proved correct. The bubble burst and global stocks suffered a torrid time between 2000 and 2003. This was primarily a valuation effect – a substantial de-rating of equities as the bubble deflated – but it was compounded by a mild decline in earnings.
This was a severe bear market for the index, but it was possible for active, valuation-oriented fund managers to add value. Neil’s funds continued to rise in value in 2000 and 2001, despite the index declines. 2002 was a much more difficult year, however, as the bear market became more broadly-based as it approached the bottom.
From 2003 until 2007 we had another sustained earnings driven market rally. With the benefit of hindsight, we know now that much of this earnings growth was illusory – the product of easy money, low interest rates and increasing levels of debt. These excesses eventually triggered the financial crisis, in which much of the earnings growth that preceded it was wiped out.
Global stock markets suffered their second severe bear market in a decade as a result of the financial crisis. The market de-rated in 2008, becoming cheaper in anticipation of the earnings slump that followed in 2009. We then had a very sharp re-rating in 2009 which, again, was followed by a temporary improvement in earnings – the “dash for trash” as it became known, was the market rising in anticipation of a “normal” economic recovery.
By 2011, it was becoming clear that the economic recovery was not at all normal, and global equities suffered a setback as the market de-rated modestly and earnings growth started to cool.
But the part of this chart that initially struck me as interesting is the period from 2012 to now. This is the best illustration I have found to date, to support what we have been saying about current market vulnerabilities. Markets have been driven by QE, not by fundamentals. Global stock markets have risen by virtue of a re-rating – the market rally has not been supported by earnings growth.
So what will happen next? Markets cannot continue to rally in this way forever. A wide gap has opened up between valuations and fundamentals. This is what Irish economist David McWilliams, describes as the “wedge between soaring asset prices and the anaemic economy underneath”.
One of two things could happen: either earnings slowly grow into the valuation that now exists in equity markets or, in the absence of QE, asset prices retreat to a level more appropriate for the economic fundamentals. Our cautious long-term view of the outlook for the global economy suggests to us that the latter is more likely.
These are words of caution for global stock markets.
In some respects, there is a strong parallel here with the stock market conditions of the late 1990’s and the dotcom bubble. The market temporarily forgot that the fundamentals matter. Now we’re not predicting the same scale of index declines that followed the technology bubble burst – the valuation excess this time round is not as extreme.
But we are still confident about the prospects for the portfolio. Some stocks have proven they are capable of growing even in a more difficult economic environment and we have built a portfolio around the most attractively valued of these opportunities. We believe that they will continue to deliver sustainable long-term earnings and dividend growth and our confidence in the long-term prospects for the portfolio, therefore, is undimmed.
But when fundamentals do reassert themselves, we know from history that active stock pickers can continue to add value, even with a broader market in decline.