Record high share prices have been “legitimized” by record high profits. The huge corporate profit gains of the past few quarters were critical in sustaining this equity market rally.
Citi analysts disagree with other analysts who say that the broad equity valuations are highly troubling. Present global equity valuations – unlike the late 1990s period – are very different from US valuations. Non-US equities trade at a 25% valuation discount to the US overall. US “value” shares also trade at a similar discount. Both measures are close to their long-term average valuation. Only Tech shares are expensive, but they have much higher sustainable growth rates.
Even with all the earnings news, investors remain worried. With the tailwinds of stimulus fading, the Federal Reserve set to reduce the amount of emergency credit it has been pumping into the economy, a resurgence of COVID-19 and worries about rampant inflation, investors are asking themselves “Can This Go On?” – Can equity prices move even higher?
Citi analysts believe we are far from an economic peak. Absolute EPS gains averaging 7% to 8% in the next 2 years are consistent with positive equity returns. Citi analysts expect further new record highs ahead, but with gains made at a slower pace with higher levels of volatility.
During periods like this – where earnings growth is strong but slowing – intra-year corrections become more prevalent. They also tend to be shallow. Citi analysts believe market timing is a bad idea during such periods. Corrections are typically short and subsequent returns tend to outweigh the “anxiety” of volatility.
Strategies to improve the quality of portfolio assets, focus on the total return from equities including dividends and diversify portfolios to specific emerging markets and to specific segments, are all ideal for this environment. Such a strategy may reduce portfolio drawdowns if and when they do occur, while capturing much, if not all, of the upside as the economic expansion continues.