UK Stock Markets have been hitting a series of all-time highs in recent months. It’s a similar story in both European and US markets. Reports in the financial press have often been euphoric.
Stock Market highs shouldn’t really be newsworthy at all because by their very nature stock markets generally increase over time. As economies expand and corporate earnings grow, stock markets should continue to rise and produce new highs on a regular basis, albeit with the occasional set back.
The reason recent stock market highs have attracted so much attention and media coverage is quite simply because this hasn’t happened very often this century. Indeed, the record high for the UK FTSE 100 set in December 1999, lasted more than 15 years until early 2015.
It was the fall in sterling in the second half of 2016 and the boost this has given to corporate overseas earnings, that has propelled the FTSE 100 to a series of new record highs. Stock markets in the US have also breached previous highs due to the “Trump Trade”, a favourable economic outlook based on the President’s election promises to reduce taxation, increase government infrastructure spending and deregulate the banking sector.
After a long period of strong upward returns, some investors might be tempted to avoid the risk of a market pullback by banking some profits.
Trying to time stock markets is notoriously difficult at the best of times. However, some financial commentators are attempting to justify this action on the basis that by one valuation measure, P/E ratios (the share price of a company divided by earnings per share), equity markets now look expensive by comparison with historical P/E ratios. This valuation measure is, however a blunt tool as it disregards the potential for earnings to rise (or fall).
There are other valuation measures which need to be considered, particularly the relationship between P/E ratios and bond yields. Interest rates and yields on bonds have fallen steadily from double digit returns in the late 1980s to the current historically low levels. If it was possible to invest in a 10-year government bond with a yield of 4% (roughly the historic average), then current equity valuations would look less attractive.
However, with current bond yields of circa 1.3% the same argument doesn’t hold good. On this basis equities are reasonably priced. Although interest rates may well rise in the not too distant future, they are unlikely to reach the historic average for many years to come. With central banks continuing to provide a surplus of liquidity, it seems reasonable to assume that equities will continue to deliver positive returns for the foreseeable future.
Of course, risks can always appear on the horizon; an escalation of geopolitical tensions, lack of strong economic growth and China credit fears, to name but a few. Diversification of asset classes and a broad investment spread with active management are the keys to reducing investment risk. This provides investors the best chance of achieving steady investment returns over the medium to long term.
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