Global equity markets have been somewhat directionless over the past few weeks, likely taking a breather after a reasonably good first quarter. Investors are digesting recent jobs reports in Canada and the U.S. Meanwhile, the consensus view remains that rate cuts are looming in the second half of the year though the exact timing and degree of cuts are topics of debate given recent comments from a few officials at the U.S. Federal Reserve. Given the strong global equity market gains over the past year, we discuss market valuations and return expectations going forward.
We have and continue to be guided by a simple but intuitive framework for longer-term investing. In essence, it suggests that long-term returns can be particularly rewarding when investments are made at inexpensive valuations. Likewise, investing results have proven to be less satisfying, over time, when investments were made at elevated valuation levels. Importantly, this guideline has no real bearing on investment returns from one year to the next. Rather, it has proven particularly useful for investors to use this over longer time frames to help assess the long-term return potential of various asset classes. Reflecting on this basic rule recently has led to us to ask the question: where are valuations today? And importantly, what expectations should we have for longer-term returns from equities?
On the surface, the large cap U.S. stock market, as measured by the S&P 500 index, appears expensive. That’s not that surprising given how well it has performed since the lows reached in the fall of 2022. Its forward Price to Earnings ratio, which reflects the current price divided by the earnings expected from the companies within the index over the next twelve months, currently sits at about 21. That compares to its average of 16 over the past twenty to thirty years. But, as has been well documented in recent months, the gains of the U.S. market over the past year have been heavily influenced by the performance of the “Magnificent 7”, a group of seven large technology stocks. If we strip out these seven stocks, the market’s P/E ratio falls to a more reasonable range of 17-18. In other words, the U.S. market is not cheap but may not necessarily be as expensive as one would think.
A similar story exists elsewhere. The forward P/E ratio for the Canadian equity market is just below 15, which is around its long-term average. The same ratio for overseas developed markets is also just below 15, which is slightly higher than its long-term average. In emerging markets, the ratio is nearly 12 which is also just above its longer-term average.
The key takeaway is that despite the fact equity markets have done well since the lows reached in 2022, the valuation levels, outside of some of the largest technology stocks in the world, are not necessarily at the kind of elevated levels that would suggest investors need to meaningfully recalibrate their long-term return expectations. Nevertheless, should markets continue to march forward without a meaningful pick-up in earnings, we may have to revisit this exercise as it could be indicative that markets have pulled forward some of the future return potential from the asset class.
Should you have any questions, please feel free to reach out.
David Blair
This information is not investment advice and should be used only in conjunction with a discussion with your RBC Dominion Securities Inc. Investment Advisor. This will ensure that your own circumstances have been considered properly and that action is taken on the latest available information. The information contained herein has been obtained from sources believed to be reliable at the time obtained but neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers can guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell or the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers is to be under any responsibility or liability whatsoever in respect thereof. The inventories of RBC Dominion Securities Inc. may from time to time include securities mentioned herein. RBC Dominion Securities Inc.* and Royal Bank of Canada are separate corporate entities which are affiliated. *Member-Canadian Investor Protection Fund. RBC Dominion Securities Inc. is a member company of RBC Wealth Management, a business segment of Royal Bank of Canada. ® / TM Trademark(s) of Royal Bank of Canada. Used under licence. © 2024 RBC Dominion Securities Inc. All rights reserved.