Chart of the Week - Do Valuations Matter?
What valuations tell us about the risk vs return outlook...
Chart of the Week - US Equity Risk Premium Risks
The Value of Valuations: You’ve probably seen the various claims and even data that say valuations don’t matter. Most of this pertains to the short-term outlook, and most of it focuses on valuations as a standalone or refer to a single lens on valuations.
But this misses a couple of points:
Valuations are 1 piece of the puzzle, and it can be hard to figure out the full picture with only 1 piece of the puzzle!
Using only 1 valuation indicator can give an incomplete or even sometimes inaccurate assessment of the true picture.
Valuations often don’t matter through the range, but can have very important tactical and strategic implications on the risk outlook at extremes.
Valuations are an important piece of the puzzle and not including that puzzle piece can lead to an incomplete picture no matter how much of the rest of the puzzle you think you’ve put together.
Valuation signals take on much greater importance when the broader macro picture aligns, and especially relative to other asset choices.
So keeping all that in mind, and studying the chart below we find US equity absolute valuations (PE ratio vs history) are elevated: aka expensive. Comparing US equities to US treasuries, the signal is similar (stocks are expensive vs bonds).
Indeed, as bond yields rise the opportunity cost of pursuing equity risk (vs the risk-free* alternative) rises, and the more attractive bonds become vs equities.
At this point we are getting 2 signals from 2 different indicators that tell us the stock market is expensive. Given that monetary policy is tight and tightening, macro data is softening, and sentiment is consensus bullish on stocks (and bearish on bonds), pursuing equity risk at this point of the cycle is a risky prospect.
Key point: Valuations are an important signal with an important message right now.
n.b. Check out the full archives of the Chart Of The Week for more charts.
Aside from the Chart Of The Week, this email gives you a brief overview of what was covered in our latest Weekly Insights Report (this email provides a free preview of the Topdown Charts premium service on Substack).
Topics covered in the latest Weekly Insights Report
Aside from the chart above, we looked at a bunch of other charts across some important and interesting macro/asset allocation issues:
Market Update: equities, risk pricing, treasuries, commodities…
Bond Yields: outlook for bond yields, implications for risk assets
Credit Spreads: balance of risks for credit spreads
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Callum Thomas
Head of Research and Founder at Topdown Charts
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