This article has been compiled exclusively for Dynasty clients by Dr Lance Vogel from Analytics Consulting, who is represented on the Dynasty Investment Committee.
It is a well-known fact that corporate earnings (E) are a very influential driver of share prices (P) over the long-term. As a result, investment strategists will study the performance of share markets and their earnings-driven characteristics through aggregate index measures of collections of these shares. The global equity market is characterised by the MSCI All Countries World Index of shares and it is this measure that is often used by market participants to formulate current and forward-looking views and opinions that will inform investment strategy. In particular, it is the trends in earnings and equity market prices and the correlations between the two, that can be utilized to formulate investment policy on an ongoing basis.
Time-based trends in the movement of global equity prices and the expectation of future earnings (forward earnings) and the correlations between the two can be used to develop a measure of the extent to which the relationship between equities and earnings is behaving as expected, or whether this relationship is showing some form of strain or disconnect. The chart below shows this relationship over the last 18 years for the global equity market. The fact that this relationship shows mean-reversion characteristics is very important in formulating investment strategy since it suggests that any disconnect between the P and the E will be eliminated at some time in the future.
In the last few years there have been two examples where this disconnect has emerged and then been rectified by an appropriate response from the equity markets. In the final quarter of 2018, global equities fell by 17% while forward earnings expectations remained resilient. On a 12-month basis these earnings expectations had actually been upgraded by 11% and a significant disconnect between equity market behaviour and earnings trends had thus emerged. On the assumption that global equities had lost sight of the resilient earnings outlook, the correct investment strategy was to maintain appropriate levels of global equity exposure in portfolios on the expectation that the equity market would rebound. Relative to the E, the P was very pessimistic.
The global equity market then rallied all the way through 2019 and into early 2020 and by 12 February 2020 the gains from the low of 24 December 2018 were 33%. However, during this rally, the global equity market lost sight of a stagnating earnings outlook as the expectations for growth in forward earnings evaporated over the course of the year. This time, relative to the E, the P was very optimistic. Yet again a disconnect between the behaviour of the global equity market and the underlying earnings outlook had emerged and thus some form of response was to be expected. Would the earnings outlook be significantly upgraded for 2021 to match the equity market expectations or would markets have to capitulate in the face of a stagnant earnings outlook?
The unexpected arrival of the Covid-19 pandemic provided the catalyst for market action. The severe lockdown regulations implemented by governments across the globe put tremendous pressure on the global earnings outlook and rapid revisions drove these earnings expectations down aggressively. The lofty forward-looking view embedded in equity markets was shattered and from the peak, on 12 February 2020, the MSCI All Countries World Index had plunged by -34% as at 23 March.
By the end of March, the disconnect had been eliminated and the long-standing correlation between equities and earnings had been restored. However, while the global equity market rallied once again, the earnings outlook has continued to deteriorate and the disconnect has now re-emerged. The chart below shows that while the global equity market is now up by 37% from its March low, forward earnings for 2021 have been lowered by -21% over the same period of time.
The global equity market seems to have lost sight of a poor earnings outlook and has chosen to reflect a very positive outcome in conquering the Covid-19 pandemic, a very rapid reopening of the global economy, and a remarkable rebound in the earnings outlook for next year. Global equity markets are very expensive at current levels. The chart below shows the price at any point in time that has been attached to 12-month forward earnings for global equities.
This price-to-forward earnings ratio (PE) has not been this high for 20 years and is a reflection of the extreme levels of optimism that currently dominate the global equity market. The current forward PE ratio of 21.9 should be compared with the average ratio over this 20-year period of 15.3. It is also instructive to note that the forward PE ratio had fallen to the average level by the end of March, meaning that future earnings were being fairly priced at that point in time.
The current drivers of equity markets appear to be behavioural and not fundamental. The earnings fundamentals suggest that equity markets should be at much lower levels, while equity markets are suggesting that the earnings fundamentals are far too pessimistic.
Equity markets (P) could move sideways from here for quite a long period of time as they wait for the earnings recovery (E), but if forward earnings expectations (E) remain muted and a full global recovery from the Covid-19 pandemic remains elusive in the short term, there is a high risk that the global equity market (P) will suffer a significant reversal as the long-standing correlations between the P and the E return to a neutral level.