It was another volatile month in what has been a volatile and trying year for investors. Despite the negative headlines, markets recovered off recent lows and ended stronger for the month. Unfortunately a sharply rising New Zealand dollar in November took the lustre off these returns.
To provide a sense of this, the S&P 500, a measure of the performance of the United States share market, was up 2.0% in US dollar terms for the month but when translated back into New Zealand dollars this turned into a fall of 3.0%. A stronger Kiwi dollar is great news if you are planning to go overseas or to fill the car up with petrol (lower prices are coming just in time for Xmas) but it’s not so good for your investments overseas!
We build portfolios with the knowledge that fixed income helps cushion the blow when share markets fluctuate. This was the case in October although it was the fixed income issued by governments rather than companies that was the best performing. Company debt tends to echo stresses in the share market, and this was definitely the case in October especially for the more indebted companies around the globe.
Despite the stronger end to the month, it has been a challenging year. When markets are difficult, it pays to step back from the noise and go back to first principles.
Valuing the share market
Over time the value of any company or its share price reflects two things – how much profit it will make in future and what investors are prepared to pay for these profits.
One way that we look at what investors are prepared to pay for future profits is a price/earnings ratio, or PE ratio in market shorthand. A PE ratio is simply the value of a company divided by its earnings or profits.
While we often use a PE ratio for considering the value of an individual company we can use the same idea for looking at the share market in aggregate. Over the past five years the United States share market, as an example, has had an average PE ratio of 16.6x; for every dollar of earnings, investors have been prepared to pay $16.60.
The selloff in shares in the past two months has led to a material reduction in the US market’s PE ratio. At the end of the last year the market PE was around 18.5x. This was above the average of the past five years. Based on current expectations for earnings, US shares now trade on a PE of 15.5x. This is cheaper than they have been in three years and comfortably below the five year average.
The Future Outlook
Does this make shares a stand out buy today? Not necessarily. The other factor that drives the value of shares is the outlook for company profits or earnings. Maybe weaker prices are telling us companies will grow profits less in the future than they have been recently?
We have some sympathy for this view. The global economy has been strong, particularly in the United States. We expect economic growth in 2019 to be lower than it was in 2018. This will undoubtedly mean that company profits don’t grow as rapidly next year as they did this year. In short, some of the fall in share prices has been warranted.
Lower growth is not exactly a disaster and is vastly different than expecting future earnings in total to be materially lower. It’s only if we saw the risk of an outright profit recession would we believe that further caution would be warranted. For now the investor expectations have been sensibly reset, the trade rhetoric between President Trump and Chinese Premier Xi has simmered down a little and interest rates are off recent highs. This is a recipe for lower volatility.
It’s December, and so I can ask Santa for my Christmas present. This year I am asking for a little less volatility so that the long-term positive fundamentals in our companies can reassert themselves. It will be good for all of our nerves if the big guy delivers!
Have a wonderful lead in to your Christmas break.