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Using the P/E test

The number of investors questioning the sustainability of the stock rally over the past months is increasing. European stocks have gained nearly 40% since their low in mid-March and nearly 13% year-to-date. While the overall sentiment seems to remain positive due to improving macroeconomic news, especially in the US, investors in Europe are awaiting positive news from the corporate earnings side. Investors are especially plagued by two developments. First, they feel uncomfortable due to the increased stock market valuation; second, they are concerned about the narrowing earnings yield versus bond yield gap, which has gained a lot of attention in recent years. Although the rally was impressive, we believe that valuation levels are at least fair and that stocks still offer superior return perspectives on a medium- and long-term basis.
European stocks are now priced at 21 times previous earnings. There are various alternatives for judging market valuation levels. One of the worst is to compare current P/Es with historical averages. With an average P/E ratio for European equities of 15 over the past 30 years, equities would look expensive. However, since P/E measures the price per unit of earnings, this price will change over time just like the prices of other assets offering income (for example, bonds) will change. This means that the current P/E need to be linked to the overall level of interest rates.
One way of doing this is to plot year-end P/E levels of European stocks versus the inflation rate over the respective year (see graph). It shows a remarkably strong inverse relationship between stock valuation and inflation. High inflation comes along with low equity valuation (therefore high earnings yield levels) and vice versa. According to this picture, the achieved valuation level of European stocks seems to be in line with a long- term equilibrium value determined by the current 2% level of inflation. Although stocks have rallied over the past months we are some way off overvaluation. This is good news since it limits the downside risk.
How do stocks compare to bonds on a yield level? The current European P/E of approximately 21, based on last year’s earnings , implies an earnings yield of nearly 5%, which means that for every e100 you invest in European companies you should get back e5 a year on average for an infinite time. This return is in real terms and will on average grow with inflation. More important, the result holds as long as corporate profits stay at least at current levels. The latter assumption does not look very ambitious given last year’s drop in corporate earnings.
Bond yields on the other hand have risen parallel to the stock rally from their low of 3.5% in June to 4.5% just recently. Higher bond yields together with risen equity market valuations make stocks look relatively more expensive now than a couple of months ago. One should, however, focus more on the economics. On a forward-looking inflation adjusted perspective, the 5% earnings yield is in real terms and compares to a 2.5% real bond yield. Even with a highly conservative assumption of zero medium term earnings growth in Europe, stocks should offer an economically significant real risk premium of 2.5%. We see no other major liquid asset class offering an expected real return in excess of 5% like stocks over a reasonable long time frame. We believe that any strategic asset allocation should comprise a substantial part of stocks.
On a tactical level, we run a medium overweight of equities relative to bonds in our European balanced funds. While the positive contribution from the earnings-bond yield gap naturally declined, almost all fundamental factors in our model contribute positively to our current equity forecast. This fits into a neutral to slightly negative outlook on euro bonds, further supporting the overweight of stocks.
Andreas Sauer is managing director and CIO of Union PanAgora Asset Management in Frankfurt

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