The first 29 days of October put markets on track for their worst month since the financial crisis. Then the selling abruptly stopped and buyers rediscovered their animal spirits. Since Monday’s low, global equities have rallied close to 5%, erasing a significant portion of October’s plunge. Even more interesting, there has been no clear catalyst for the rally, leaving some to suggest that stocks were simply too cheap to ignore.
From my perspective, the rally of the last several days looks like a technical bounce, i.e. a short term exhaustion of selling, rather than bargain hunting. To be sure, there are pockets of the market—notably Japan and many emerging markets—that could be described as cheap. But at the broader level, and particularly in the United States, it is difficult to argue that stocks got so cheap buyers simply could not help themselves.
Developed market equities are trading close to their historical average, with the MSCI World Index currently at roughly 14 times forward earnings (see Chart 1). Looking at price-to-book (P/B) suggests the same conclusion. The MSCI World is trading at 2.25 times price-to-book (P/B), right around the long-term average.
Looking at more recent data also suggests that valuations are close to the middle of the range. The P/B on the MSCI World Index is roughly 6% cheaper than was the case in late January. That said, stocks are about 10% pricier than two years ago, just prior to the post-election rally.
The argument that stocks were more attractively priced in the fall of 2016 is supported by the fact that bond yields were also much lower. Right before the 2016 post-election rally, the U.S. 10 year Treasury was yielding approximately 1.80% and German Bund yields had just recently crossed back above 0%. In other words, not only were stocks modestly cheaper on an absolute basis, they were much cheaper once you adjusted for interest rates.
Two bullish scenarios
To be fair, none of the above suggests that the near-term bounce won’t continue. Certain segments of the market are trading below their long-term average, and even at the index level stocks are less egregiously priced than was the case in late January. However, not being egregiously priced is not the same as being cheap. With U.S. rates up nearly 150 basis points (bps, or 1.50% points) from the fall of 2016 and the Fed still tightening, it will be harder for multiples to expand from here.
So what could provide the necessary boost to sustain the rally?
I can think of two scenarios: rising growth expectations, such as we saw with the stock market rally in late 2016, or modest growth coupled with easier financial conditions, i.e. something closer to the rally during the first half of 2017. In the first instance, expect value and probably financials to lead. The second scenario would arguably be characterized by a return of king tech. In the absence of either, expect more volatility.