Forget the headlines. Headlines do not earn return on equity for companies. Look instead to the evidence presented on a day-to-day basis. There is good, strong profitability and corporate performance globally.
Corporate governance is improving almost everywhere. There are attractive valuations for both equity and credit. Returns on equity, price to book, earnings yields, price/earnings ratios, and yields on credit products reflect attractive valuations and good prospective returns. The returns and premiums gulf between low risk assets and mid-high risk assets is not rational. A deep-seated crisis mentality contributes to this valuation disparity, but also could represent a buying opportunity.
Attractive valuations, however, do not necessarily mean there will be a bull market any time soon. Too many people are convinced the market is in a permanent state of crisis. This is a similar point as during the recurring crises of the 1970s and 1980s. Today, as it was then, the prevailing conventional wisdom is pro-crisis and cynical equals smart.
Once in that mindset, it is difficult to move quickly or easily to a bullish position. A crisis by its nature creates displacement in psychology, fear and concerns about loss and risk. The good news for today's investors is that valuations are attractive. The bad news is that these valuations may persist for some time.
A strong, sustained and growing gap between the return on investable assets and the cost of capital continues to be the prevailing success factor in investing. That is where the market is now.
This value creation will lead the way into the next cycle. The data in the following table showing earnings and dividend yields against risk-free bond rates reflects this reality (figure 7). In the U.S. the earnings yield is 8.2% corresponding to a price/earnings ratio of about 11% against a bond yield
of 2.1%. This earnings and dividend yield gap is normally about 3%. When the gap is over 6%, as it is currently, it means the odds are in favor of investing in any kind of risky assets. The same is true for high yield and investment grade corporate bonds. Odds are also improved for other risky assets such as REITs, real estate and other types of real asset investments.
This is true globally. For the first time in over 50 years, government bond yields are lower than equity dividend yields in every major developed market in the world. The credit side is also worthy of attention. The spreads of various investment grade credits over risk free rates, compared to credit/loss ratios are shown in the following chart (figure 8). The “A” rating in this illustration reflects the average
company rating in the S&P 500. On average there has been a 2% spread of A-rated bonds over the risk free (though it is now approximately 2.5%) case. The chart shows that the loss experience for A-rated bonds is generally less than 0.2% and occurred in six different years over a 30 year period. Yet during that time, investors were paid a 2%-3% premium annually for an average loss of less than 0.1%. With these returns more elevated than usual, the return prospects are very favorable under almost any reasonable and realistic set of assumptions.
Where is the market today? When evaluating long periods of returns in equity and bond markets, it is clear that most of the time market returns are not average. Returns are usually worse than average in a bear market or better than average in a bull market. The return expectations depend on where action is taken in which part of the cycle. We are currently very late into the third down leg of a flat to down cycle. The market peak in March 2000 was followed by a two year bear market, which was then followed by one in 2008-2009. This year's third bear market has been experienced to a lesser extent because the
market started from a lower base. The last time the market had a similar cycle was in the 1966-1982 period, when there were also three major down markets. Each time the psychology got worse and more deeply embedded. However, the closer to the end of this type of cycle, the better the prospect for improved
long-term returns.
There are three key messages we can apply to investment strategy today. First, look for return seeking strategies. In other words, seek out risky assets and think about how to make money, not how to avoid losing money. Second, think about what the best opportunities are and be selective about investing in them. Tactically shifting allocations and trying to game the market in various ways will not work. The best way to take advantage of current market conditions is to select effectively from among the return opportunities available.
Finally, the best way to do that is to prioritize the fundamentals: value creation, governance, quality, and the fundamental characteristics that create the returns on assets that translate into the returns that investors earn.
The above is an excerpt from the 2012 market outlook of W. George Greig, global strategist and portfolio manager at William Blaire & Co. To read the full version, click here.
