Should investors fear equity vertigo?

Climbing higher than ever before can be scary. The S&P 500 Index of US stocks is around 2% below its record. And the MSCI All Country World Index of global equities is just 1% shy. Looking down from these heights (which are above the 30-year-average equity valuations in Switzerland, the US and the UK), some investors have been withdrawing funds from stock markets. Investors pulled USD 14.5bn out of US equi-ties in the week to April 5 based on EPFR data, the largest weekly exodus since September 2015.

Investors pulled USD 14.5bn out of US equi-ties in the week to April 5.

We nonetheless see a positive case for equities, and hold overweight positions in global and US stocks against US government bonds. Here's why:

1) Record highs do not mean the market has peaked: A common behavioral bias can lead investors to “anchor” on a recent record, and assume it will be difficult for stocks to advance beyond it. But historical data suggests that record highs need not be market peaks, and that staying invested pays off. In fact S&P 500 figures from the past half-century show the market has returned an average of 4.6% in the six months after hitting an all-time high, compared to an average of 3.6% over the whole sample period.

2) Economic good news justifies high valuations. Valuation measures mean little in isolation from the macroeconomic context, and stocks are typically worth more during times of robust economic growth, low unemployment, and moderate inflation. Trailing price/ earnings (P/E) ratios for the S&P 500 Index have averaged 19.9x in the months since 1960 that feature the lowest 10% of readings for the US economic misery index (the sum of the jobless and inflation rates). Today the misery measure stands at 7.2% while the S&P 500’s trailing P/E of 19.4x is in line with its average valuation when the misery index rests in a 7.1–7.7% range. We expect US first-quarter earnings season to confirm that firmer eco-nomic activity is feeding through into solid earnings growth. In fact the expected 12% year-on-year rate we’re looking for in 1Q should be the best quarterly result in nearly six years.

Leading indicators of global economic growth also imply further gains for global stocks. According to Goldman Sachs, the MSCI World Index has generated an average 12-month return in excess of 10% since 1990, when global composite purchasing managers’ indexes have climbed year over year. As of March this sentiment gauge was up 2.4 points, which bodes well for economic and earnings growth. And with valuations trading 1% below the 30-year MSCI World Index average, we believe the global equity rally still has room to run.

Historical data suggests that record highs need not be market peaks, and that staying invested pays off.

3) Above-average valuations don’t mean a bear market is looming. Richer valuations need not necessarily weigh on subsequent six-month returns. Current trailing P/E ratios for US stocks are consistent with subsequent six-month returns averaging 6%. Longer-term valuation mea-sures using smoothed earnings over a decade (such as the Shiller P/E) do suggest that current valuations of 25–27x have historically led to average five-year total returns of 4.5%. That does not necessarily imply that investors should sell down US stocks on a five-year time horizon. It does speak, though, to diversifying into global equity markets (where prospective returns look more appealing since cycle-adjusted valuations for developed and emerg-ing markets alike are trading below their three-decade averages, according to data from Citi).

4) Equities remain good value relative to other asset classes, especially government bonds. Comparing stocks to other asset classes makes just as much sense as contrasting US stock valuations to global ones. A yardstick for their relative appeal over government bonds, the equity risk premium for US, European, Japanese, and developed markets, stands at least one standard deviation above its long-term average.

Bottom line

Stock valuations are less demanding than they initially appear. Against the backdrop of a synchronized acceleration in global growth and a broad pickup in earnings, global equities are still well-placed to make further gains. Rather than succumb to vertigo, investors, in our view, should stay invested in stocks…and enjoy the view. We are overweight global and US equities in our global tactical asset allocation.

Rather than succumb to vertigo, investors, in our view, should stay invested in stocks…and enjoy the view.

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