2018 was a rumbustious year for stock markets, with things really coming to the fore in the latter stages. With investors having grown accustomed to an unusual calm over recent years, volatility was back with a bang.
However, as the dust settles, there is a silver lining. Even before the fourth quarter downturn, markets had been cheapening in valuation terms.
Improving fundamentals were behind this shift. Profit growth for 2018 is projected to have been a hefty 24% for the US market, although this is partly down to the Trump administration’s tax reductions.
UK and emerging markets are also both forecast to deliver double-digit earnings growth, while Europe is around mid-single digit levels.
Japan is bringing up the rear with only 3% earnings growth, but it saw its fair share of weather-related troubles in 2018.
Even if share prices had ended the year where they started, investors would now be in a stronger position from a fundamental standpoint. In simple terms, they would now benefit from more earnings for each dollar that they have invested.
However, recent events mean that share prices weren’t flat over 2018, they fell sharply. That means that not only are earnings higher, but prices are lower. This double-whammy has pushed popular earnings-based measures of stock market valuations close to their cheapest levels for many years.
Relative to consensus earnings forecasts for the next 12 months, US, UK, European and emerging market equities are valued at close to their cheapest levels for four to six years. There is a similar story when prices are compared to the previous 12 months’ earnings. Japanese equities have not been cheaper on either basis since the depths of the financial crisis.
Other valuation measures have also cheapened – cyclically-adjusted price earnings and price-to-book multiples have fallen and dividends yields risen. The UK dividend yield has even risen above 5%. If you exclude the financial crisis, this is its highest level for over 25 years.
The consequence of these moves is that, from a valuation perspective stock markets are now a much more appealing prospect than before. Whereas, as we entered 2018 our valuation table was a sea of (expensive) red, it is now a field of (cheap) green. With the exception of the US, all other markets are now outright cheap on most valuation measures. Even the US is less expensive than it was. (All of the valuations measures are explained briefly below).
While there are undoubtedly short-term challenges facing markets, not least geopolitics, tightening monetary policy and slowing global growth, investing when valuations are cheap is a sound long term strategy. Valuations are the single biggest determinant of long term returns, although their uselessness at predicting short term market movements should always be borne in mind.