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June 12, 2017 | GSAM Connect

Putting US Equity Valuations in Context


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By Heather Kennedy Miner

US equity valuations are high by conventional metrics. But viewed in the context of low interest rates, a continuing global economic expansion, and metrics such as the equity risk premium, we see a more nuanced picture, one where valuations are justified and even defensible.

We would stress that valuation alone in the past typically has been a condition more than a catalyst for market moves. Equity-market corrections generally require an external shock of some sort. Valuations on the whole have been stubbornly persistent. Forward S&P 500 Index price-to-earnings ratios have held above the 80th percentile for as many as five straight years in recent decades (1997-2002).1

At the same time, elevated valuations underscore the possibility of modest equity returns in the coming years and in our view leave investors less room for error as they construct their portfolios.

Exhibit 1: Global Equities: Relative Valuations

Source: Bloomberg, Goldman Sachs Global Investment Research, MSCI, Local Index Compilers, FactSet, I/B/E/S, Tokyo Keizai, and GSAM as of 1/31/2017.  Please see additional disclosures at the end of this document.

Volatility could be headed higher

In periods of elevated valuation, our base case is that investors will need to work harder to achieve increasingly modest returns. Investors may be tempted under such circumstances to take on greater risk for each unit of return as a response. We think that would be a mistake.

Early 2017’s historic lows in volatility, as measured by the CBOE Volatility Index (VIX), strike us as a mispricing of persistent political risk across markets. Anticipation of pro-growth Trump policies has seemingly shielded equity markets from the policy-induced uncertainty in currency and fixed income markets. Emmanuel Macron’s victory in the French elections in May could be viewed as suggesting the populist tide in Europe has ebbed.

As mid-May’s rocky trading suggests, we think political risk has more surprises in store for investors. Low VIX levels and placid equity markets strike us a temporary phenomenon; the VIX has traded above its first-quarter average for over 90% of its history.2

In an environment of modest expected returns and higher volatility, a fresh look at strategies designed to reduce risk may be warranted. We remain cautious on pure market beta.

Earnings power ‘for the win’

We look to earnings growth potential to drive equity returns during 2017. Deregulation, potential tax reform and more populist trade policy are three reasons we think investors must use a nontraditional lens to view the pursuit of earnings growth. Top-down frameworks constructed around value-versus-growth style boxes and other conventional methods are likely to prove inadequate. We expect more than 10% US corporate earnings growth in 2017, with potential upside in 2018 in the event of tax reform.

The effect of these policy-driven impacts could be divergent across sectors of the market. For instance, the effective corporate tax rate in the US energy sector is 36% but only 25% in information technology stocks.3 The effect is not likely to be linear: A cash repatriation provision, should one be included in comprehensive tax reform, may be hugely accretive to the technology sector.

Beyond beta, beyond borders

For investors looking to diversify beyond US equities, emerging markets may offer especially attractive possibilities, as valuation imbalances recently have been less pronounced. 

Investing internationally in our view requires selectivity at both the security and country levels in the effort to reduce exposure to overextended countries – for instance China and its elevated debt levels – and in the attempt to capitalize on attractive opportunities.

We see select opportunities as well across Europe and Japan, where earnings power also remains in focus. In Japan, approximately 50% of TOPIX companies trade below book value.4

The implications as we see them: there is virtue in remaining invested, as fundamentals have aligned to justify elevated valuations. Expensive markets often remain that way. We would focus on the global opportunity set, while embracing risk management and strategies with the potential to offer risk reduction.

Heather Kennedy Miner is Global Head of Strategic Advisory Solutions at Goldman Sachs Asset Management (GSAM).


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Heather Miner

Heather Miner

Global Head, Strategic Advisory Solutions, Goldman Sachs Asset Management


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