An evaluation of equity markets
The sharp contraction in equity markets that marked the start of 2020 has been relegated to the distant-memory drawer by an almost uninterrupted 18-month rally in equities. At the time of writing, the MSCI All Country World Index (ACWI) stands modestly shy of its all-time high, having been powered mainly by North American equities; and the S&P500’s gain of 31,8% over the last 12 months lifted the index to a record 4,545 points in the first week of September.
The recovery and rally have not taken place in isolation – the tech-heavy Nasdaq and mega-cap Dow Jones also marched to all-time highs in the third quarter. The drivers have been a cocktail of fiscal stimulus and monetary relief that have encouraged investors across the spectrum: witness the sale of the non-fungible token (NFT) CryptoPunk #3100 for $7,6mn in March. The NFT is now on the market at $108,7mn, which makes for 14-times money in six months. It is difficult to reconcile these types of valuations with sound investment reasoning. At the same time, the market activity and speed with which prices have moved to capture the elevated appetite for risk that dominates the investment mood is worrying. This optimism is cause for caution.
It is tempting to regard equities as the only trick in town given yields on 10-year US bonds are at 1,3% and that yields on cash accounts in high-street British and European banks are zero or negative. Whilst equities have the potential to be powerful long-term compounders, that view needs to be moderated by specific risks, including rising inflation and associated interest rate tapering; economic growth attached to rising inequality; and the consequences of climate change. In this setting of uncomfortably elevated company prices, there are at least three ways to look after equity investments, including diversification across currencies, countries and industries; investment away from euphoric sentiment in favour of quality assets on more attractive valuations; and ownership of businesses backed by long-term structural drivers which will continue to shape the investment landscape, drive economic growth and impact business performance including automation, decarbonisation, biotech and healthcare, as cases in point.
With this in mind, equity returns from here are likely to be lower than the recent experience, but owning good assets at good prices in businesses backed by sound business models has the capacity to sustain attractive returns ahead of price inflation and the risk-free rate.