Too many bulls; not enough beef

Since fears about the survival of the Eurozone and potential recessionary impact on the world economy reached a height in September 2011, stock markets around the world have performed strongly. For example, the MSCI World Equity Index has risen by 50% in US Dollar terms. However, this global bull market has been almost entirely driven by rising valuations, rather than by earnings growth. Valuations of many equity markets are now back at the high levels seen in 2006-07 and, in the absence of earnings growth offer limited upside for stocks.  We do, however, see scope for valuations to rise in Asia and Japan, and have most confidence in the earnings outlook of Japan and the UK – these markets are our preferred areas for equity investment. Conversely, the European and US markets are likely to underperform on a relative basis over the next few quarters.

The most commonly used valuation tool by investment analysts to analyse shares is the Price-Earnings ratio (“PE”) – the share price divided by the earnings per share (“EPS”) of the company. The lower the PE, the cheaper the share is considered to be. A share price is likely to rise if the company’s earnings grow, or if investors expect increased earnings quality in the future – this is reflected by the PE rising. Over the long term, EPS can be expected to rise in line with the growth in the global economy, while the PE tends to be mean-reverting around long term norms.

Too many bulls

Since 30 September 2011, the point of greatest concern that a collapse of the Euro might trigger an even deeper world recession, the MSCI World index has risen in price by about 50% in US Dollar terms (about 40% in Sterling). The table below breaks this performance down between the change in forward EPS and the change in forward PE, across the different regions of the global equity market.

  Analysis of MSCI Index performance during the 30 months from 30/09/2011 to 31/03/2014
Index Price Forward EPS Forward PE Forward PE Forward PE
  % change % change % change Level on 30/06/2007 Level on 31/03/2014
MSCI Asia ex Japan $ 24.4 2.4 21.5 15.0 11.8
MSCI UK £ 27.8 -12.9 46.7 12.7 13.0
MSCI Japan Y 58.6 38.5 14.5 18.2 13.3
MSCI Europe ex UK € 49.1 -8.8 63.5 13.6 14.3
MSCI US $ 65.9 11.4 48.9 15.4 15.7
MSCI World $ 51.6 2.8 47.5 14.9 14.8

Source: MSCI, Thomson Reuters.


Column A – MSCI Index

Column B – % price change in Index from 30/09/2011 to 31/03/2014

Column C – % change in Index Forward Earnings Per Share (next 12 months)

Column D – 100 x (1+B)/(1+E) – % change in Index Forward PE

Column E – Index Forward PE on 30/06/2007

Column F – Index Forward PE on 31/03/2014




The table shows that the forward EPS (that is the forecast earnings over the next 12 months) of the MSCI World Index rose by only 2.8% over this 30 month period, but that there was a 47.5% gain in the PE, so the bulk of the gain in the index price was due to increasing valuation. This was most marked in Europe, where the PE expanded by 63.5% (though at the beginning of the period Europe was extremely cheap as it was at the height of the Eurozone crisis), and in the US, where the PE expanded by 48.9%. The Asian and Japanese markets, by contrast, have seen the least PE expansion.

Column F in the table above shows the current values (at the end of March 2014) of the Forward PE – the US and Europe have the highest valuations, while Asia, Japan and the UK have the lowest valuations. Comparing the forward PEs today (Column F) with their levels at the end of June 2007 (Column E), the valuation peak before the financial crisis and the last period of general market bullishness, suggests that valuations in both Japan and Asia are lower than those in 2007 and therefore still have scope to rise. However, the PEs for the US and Europe are higher than their 2007 peaks and appear to have little scope to increase further without moving into clearly over-valued levels. Thus earnings growth is now required if further sustainable gains in these stock markets are to be delivered.

Not enough beef

Over the long term, equity markets rise with the growth of the economy and in particular with corporate profits. Earnings growth is the “beef” that markets require to move sustainably higher. Of the global equity market regions, the US has experienced the strongest economic growth over this period, corporate profit margins are at their highest ever levels and companies have been very aggressive in their use of share buybacks. Yet, even with all these positive factors, forecast earnings have only risen by 11.4% over the 30 month period.

The weakness of the European economies is highlighted by the decline in forward earnings in both the UK and Europe. Some of this can be attributed to recent currency strength, but most of the weakness reflects the lack of demand in the European economy in particular. Japanese forward earnings fell through 2012, have risen sharply since 2013 as “Abenomics” was introduced, but are up only a little over the whole period. Japanese forward earnings are however rising at the fastest rate of all the regions.

We have the most confidence in the immediate earnings prospects for Japan and the UK, which is where we expect to find the beef. In Japan, the weakness of the Yen and the increasing likelihood of wage gains helping to increase consumer spending should continue to improve the corporate earnings outlook. In the UK, the domestic economic recovery is expected to boost the earnings of small and mid-sized companies. Meanwhile, large companies are very sensitive to the exchange rate and their earnings should see a significant boost if the recent spate of currency strength reverses.



Though we expect equity markets to deliver better returns than bond markets this year, we anticipate greater volatility than seen during the last two years.In the longer term, we remain convinced that Asian economies will deliver the greatest growth of all the regions and that this will feed through in EPS growth for Asian companies.   Our model portfolios remain underweight equities in the US and Europe-ex-UK and overweight in Asia, Japan and the UK.

A believer in the Abe lever – Japanese shares

The end of bear markets are periods when investors are delighted that they do not own a certain type of asset.  This usually means that the performance has been very poor for a long period of time, and for reasons that most investors believe will persist.  Typically, on long term valuation criteria the assets are understood to be cheap, but no one can envisage a situation whereby the valuations should rise.

Bull markets begin at the end of bear markets and tend to occur in three waves – the first wave, which we have just witnessed in Japan, occurs amid disbelief and surprise.  The second wave occurs as investors shift from disbelief to belief and it appears quite rational to buy as the fundamental news improves, and the third and final wave is the bubble wave as investors shift from belief to high conviction that prices must continue to rise, because the fundamental story is so compelling.  Between each wave is some sort of correction, which can encompass sharp falls in share prices.

Japanese shares were in a bear market for 23 years from 1989 to 2012 – there are probably few investors around today who can remember the last time Japanese stocks were in a bull market.  The major indices had fallen by 75% over that period, and by last year the equity weightings of domestic Japanese financial institutions were minimal and their portfolios dominated by government bonds with near zero yields.  In addition, many international investors were extremely comfortable with low or zero weightings to Japanese equities in their portfolios. Economic growth has been zero in nominal terms (that is including inflation) for over 20 years, and the legendary Japanese trade surplus of former decades has now become a trade deficit, following the Fukushima accident, the shutting down of all of its nuclear power plants and the consequent need to import a far greater amount of its energy requirements.  It boasted the largest government debt to GDP ratio in the developed world.  Investors who did own Japanese shares, made sure that they did not own very many, as it was so difficult to justify such positions to clients or managers.

By last autumn, over 70% of companies listed in Tokyo traded below book value, and the dividend yield of 2.5% was 3 times the yield available on a 10 year Japanese government bond, even though the dividends paid by companies in the stock market had doubled over the previous decade.  Japanese shares were very cheap but investors would not buy them, because very few believed that the Japanese economy would get back onto a path of growth.  Japan fulfilled all the conditions for an end to its long bear market.

Then, last December, Mr Abe, one of the many former prime ministers of the last decade who had proved ineffective and short-lived, and who regained the leadership of the LDP, fought a general election campaign asking for a mandate for dramatic change to set Japan’s economy on a course for growth.  His plan consisted of three pillars: (i) a short term fiscal stimulus of government investment spending, to boost demand in the short term; (ii) a shift in monetary policy aimed at boosting inflation expectations that would boost demand in the economy in the medium term; and (iii) a package of structural reforms to increase the economy’s long term potential growth rate.  This policy mix was eerily similar to that adopted by Japan in the mid-1930s, which successfully brought their economy out of the problems caused by the Great Depression.

His political timing was excellent in that: (i) the Governorship of the Bank of Japan was an appointment that needed to be made in the first quarter of 2013, and in many people’s eyes it had been the Bank of Japan’s conservative approach to monetary policy management that had been holding back the economy; and (ii) the Upper House elections were due to be held in July 2013, giving him the rather rare opportunity to gain a majority in both Houses of the Japanese Parliament at the same time, and thus be in a position not to have to compromise with opposition politicians.

In a matter of weeks, the consensus view of the prospects for Japanese markets had reversed. Rather than a stagnant economy with no change to policy, there was to be a dramatic shift to a pro-growth and most crucially to a pro-inflation stance.  At the heart of the policy shift was a change in the Bank of Japan’s inflation target from 1% to 2% and a belief and determination from inside the Bank of Japan that this could be attained.  This required a Governor who believed that creating higher inflation was possible, which the outgoing Governor did not; the change from Mr. Shirakawa to Mr. Kuroda brought this in one fell swoop.  To achieve this, Kuroda immediately announced a programme to print 6 trillion yen a month for two years, and so double Japan’s monetary base.  The aim of this programme was and is to raise inflation expectations, and encourage consumers and businesses to spend now, to hold down interest rates, and so reduce real yields in the economy, and most importantly to weaken the yen.

The weaker yen is an enormous boon for Japanese profits, whose companies sell so much around the world.  The profits of the large Japanese companies are very sensitive to the value of the yen, rising strongly as the yen declines.

Over the early months of 2013 the market suddenly found itself with increasing earnings forecasts, low valuations, enormous supplies of liquidity, and with most investors holding very little exposure to Japanese equities, but who believed that they needed far greater exposure.  The market rose rapidly, gaining almost 80% in the seven months from October 2012, to 1276 on the Topix index; this was partially offset for many international investors, who neglected to hedge their currency risk, by a fall of 25% in the value of the yen.  In the three weeks following the market peak on 22 May 2013, it has fallen back by almost 20%, though this still leaves it at the levels it was trading at in early April and 50% higher than the lows from last year.

There are those who believe that Japan has entered a bubble, but bubbles occur at the end of long bull markets, not after just seven months when many investors have had little opportunity to build positions.  The critical insight is that the market psychology on Japan has changed, from being uninvested and comfortable with that position, to being lightly invested but very uncomfortable with that position.  Apart from very short term orientated investors, who have profits to bank, and so will do so, most investors will now concern themselves with being underinvested in Japan, and so any positive news on Japanese growth, Japanese corporate earnings, easy monetary policy and a weaker currency will be seen as good news, and lead them to increase their weightings to Japan.

This summer is likely to see a continuation of the recent correction, as shorter-term investors take their profits and search the world for their next opportunity, and are replaced by longer term investors who need to build up their positions in Japan.   Thereafter, either the Japanese economy will begin to grow faster and inflation pick up a little, which will justify higher share prices, or if growth and inflation are not picking up, then the Bank of Japan will be forced into even greater money creation, and an even weaker yen which would also boost share prices.   In either event, a second wave of the bull market should be expected to begin later this year, though it will be critical to invest in Japanese equities with the currency hedged, since one of the major factors in stronger share prices will be the weaker yen, caused by the aggressive printing of money by the Bank of Japan.