Wherever one looks, there are pundits inciting fear over the equity market’s massive rise. It is a bubble for sure, or so they say, and it will have to pop. All kinds of indicators are being employed to make the case, and admittedly, some look incredibly out of place and remind of historical pre-crash scenarios. Some of my astute investor friends have been voting with their feet and disposed of most if not all their equity holdings. They prepare for the worst.
Meanwhile, however, stock prices are making new highs as if nothing could ever put a lid on them. If you can afford a longer stretch of underperformance or literally missing out on the action, like Jeremy Grantham has in the past and may again on his call this time, then it might well make sense to hoard the cash and wait. For others who are measured by performance it is a different story altogether. For them, holding cash is not a hedge against a potential crash. It is a disaster.
Let’s have a look at the numbers. The S&P’s trailing price/earnings ratio in the high 30s certainly looks lofty. Only once in modern history have we eclipsed this level, when during the dot-com bubble the ratio blew out into the high 40s. But equally, we need to remind ourselves that US growth was humming like a bird in the late 90s, whereas we are standing before the wreckage of an economy plagued by the pandemic now.
The difference in valuations these days, however, is monetary policy. The Fed has purchased unprecedented amounts of securities in the past 10 years but especially in 2020 when the health crisis hit, which has kept real interest rates well below zero. So, the logic is rather simple. When, on an inflation-adjusted basis, you have to pay your government or your bank to hold money for you, the prospect of buying equities looks a lot better, no matter what valuation they trade on.
If it was ludicrous to believe that anything will change with the Fed’s sub-zero real interest rate policy, and in light of the economic and labour market armageddon we are facing I think it is, then it would become a question of what equities to justifiably buy into, even if one was exposed to a wider correction of indices in coming months. What I mean is by what measure of valuation that is to be done, not by way of rotating around sectors which should obviously have benefits in itself.
Looking at forward price-earnings ratios of different markets we will find that Chinese shares are relatively undervalued to American, and actually by quite a margin considering a ratio of 16 for the CSI 300 and 23 for the S&P 500. The H-share index in Hong Kong sports an even lower reading of 10 times, mainly due to the index composition and political uncertainties around the city remaining a pressure point for US-Chinese tensions.
Now, does that make Chinese shares cheap? From a valuation point of view, China’s considerable economic outperformance of the rest of the world is contrasted with America’s negative real interest rate scenario. I am having my own thoughts but will leave it to readers which they will appreciate more. In any case, there should still be no reason why Alibaba, for instance, trades at roughly 1/3 of Amazon’s market capitalisation, even factoring in recent IPO and regulatory disruptions.
I found another example representative of this valuation divide, a little specific as it may be. You might have heard of a company recently gone public in the US, intriguingly called Lemonade but being an online-only insurance business. To be sure, these insurtech enterprises are hot items these days, and so is their share price movement. The stock has traded up substantially and sports a market capitalisation of around 9 billion dollars on revenues of 90 million. They recently celebrated the 1 million-th customer.
Now, there is a Chinese equivalent of an online-only insurance business, called Zhong An. The company went public in Hong Kong in 2017, will report revenues of close to 3 billion dollars, is on track to make a profit in 2020, and sports a customer base of 450 million. Lo and behold, though, Zhong An’s market cap is inside Lemonade’s at less than 8 billion. What do you know…? Of course, the comparison is far from being representative of the entire market but a snippet to pay some attention to.
