2–3
We believe that inflation is one of the factors which can help
explain some, but not all of the highs and lows of the PE series.
Generally speaking, high PEs tend to correspond with low inflation
while low PEs are prevalent at the time of high inflation. This
is because periods of higher inflation correspond with greater
degrees of uncertainty, which in turn warrants a larger equity risk
premium. Meanwhile, on an inflation-adjusted basis, the current
valuation of the US share market appears quite neutral.
On the other hand, the significant over-valuation as suggested
by the Shiller measure can be attributed to the earnings used
to derive the PE ratio. Notably, the Shiller measure uses average
earnings over the last 10 years while the other metrics use either
the earnings for the trailing 12-month period or expected earnings
for the coming 12 months. As the current earnings and profit
margins are well above their long-run moving average, the Shiller
PE implicitly assumes that actual earnings will revert back to the
10-year mean.
On the contrary, we believe that the rise in profit margins is part
of a multi-decade secular trend. In the past few decades, the
significant increase in labour population globally, largely due to
India and China, coupled with globalisation and technological
advances, helped raise profit margins. While the profit margin
in the US may fall as Chinese labour loses its low cost status and
demographics help drive a tightening in the US labour market,
these will only play out over an extended period of time. Therefore,
with the current high level of earnings relative to history not about
to mean revert any time soon, the Shiller PE could be overstating
the risk of a correction, and the shorter-term focused metrics are a
better guide for the moment.
In summary, although the US market is now fully valued and no
longer cheap, valuation metrics currently do not provide a strong
signal either way for the market’s future direction. The economic
cycle is strengthening at present, with robust earnings in prospect.
But market risks are rising as the economic recovery continues
into its later stage and the US labour markets tightens. Sentiment
indicators are also now on balance becoming bearish and need to
be watched closely. Therefore, although we continue to maintain
our moderate overweight to equities, we are keenly aware of the
risks of shorter-term se щ