The four most dangerous words in investing are: 'This time it's different’; and we have been hearing this a lot recently, says Hugh Selby-Smith, co-CIO at Talaria Asset Management.
“The boom in Artificial Intelligence (AI), a rise in big government spending programs, and high employment levels, seem to have enticed investors into this optimistic point of view.
“Scratch under the surface, however, and a different picture emerges. The market is currently offering few opportunities for investors to make decent returns.”
Mr Selby-Smith says this is particularly evident in the all-important US, where corporate earnings’ forecasts overall are stagnant or getting worse, the employment outlook is weakening, and valuations are rising from already extended levels.
“As bottom-up value investors, a key criterion is the number of stocks to which we can gain exposure that are offering 25 per cent upside to fair value. Currently, this opportunity set is very limited.
“The longer one looks, the harder it is to see a positive outlook for savers. Starting equity valuations are stretched, especially for investors in US equities, and in the long run it’s valuations that drive returns.”
Talaria’s analysis shows that since its previous peak in late 2021, the S&P500 has delivered a nominal return of greater than 10 per cent but is flat in real terms.
“Unfortunately, this is representative of what we think investors should expect to get over the next decade. Both valuations and margins are sitting near record highs, nowhere near the long-term average. Therefore the longer an investor’s time horizon, the less and less US equity exposure they want.
“Of course, what the mathematics of long-term returns do not tell you is what the market will do in the short-term. The S&P 500 index, the world’s largest, returned 16 per cent to Australian based investors in the March quarter. The FTSE World returned around 13 per cent for the same period,” Mr Selby-Smith says.
However, in contrast to strong markets, economic data continue to track lower, which is in line with what one would have expected given the rise in interest rates over the last 24 months. Growth in Leading Economic Indicators (LEI) remains negative in the first quarter. Coincident Indicators (CEI) like gross domestic product (GDP) and company earnings closely follow. If this historic relationship were to hold, CEI are set to fall. In addition, employment figures are also starting to look shaky.
“And it is not just the outlook for employment that is poor,” Mr Selby-Smith says.
“Company earnings (EPS) strongly correlate with GDP. Expectations for corporate profits in the US, outside of a handful of tech giants, has declined markedly since the middle of last year, for both this year and next. LEI suggest further pressure to earnings forecasts is to be expected.
“Stripping out the earnings estimates of the Magnificent Seven from the S&P 500, earnings estimates since 1 July 2023 for the remaining companies have declined by more than 10 per cent for both FY24 and FY25. At the same time, equity prices are up on the hope that earnings will “grow into the multiple” – even after the downgrades, FY25 EPS are forecast to be 23 per cent higher than the earnings in FY23.
“We are not making a forecast on what the future holds. Instead, we look at the odds and probabilities and caution that the path to prosperity for equity markets is becoming increasingly narrow.”
