Valuation fundamentals

Published: December 22 2009 09:35 Last updated: December 22 2009 10:09

Like death, investment fundamentals matter but are often forgotten or ignored, pushed aside by the immediacy of day-to-day living. This approach can bring happiness for years – until a life or death moment intervenes. Late last year was just such an occasion. But, since March, asset classes from stocks to commodities have soared again. Are investors deluding themselves once more?
Take bonds. Their valuation depends on the outlook for growth, inflation and, where applicable, quantitative easing programmes. A useful way for investors to think about bonds is to compare nominal yields today with historic real yields to see what expectations for inflation are spat out. For example, Merrill Lynch believes that over the past 300-odd years, real bond returns in the UK have been about 3 per cent. That means those holding 20-year gilts with a nominal yield of 4.2 per cent expect inflation to stay about 1 per cent for two decades. That’s a big call. Most other bond markets are supported by similarly low expectations for long-term inflation.

Then there are equity markets. Here it is best to use long-run, adjusted earnings based valuations, or methodologies comparing prices to real assets, such as replacement ratios. On such measures, US stocks are now almost 50 per cent overvalued, according to Smithers & Co. Unfortunately, historical data are less reliable for other equity markets, but most also look expensive on this basis, albeit to a lesser extent.

Finally, commodities and property. For the former, price rises have outpaced absolute improvements in global industrial production. The fundamentals for certain housing markets, however, look good. In the US, for example, values relative to disposable income are well below trend having fallen by more than a third. House prices are ticking up again across the globe, although the commercial sector remains soggy. Investors should not get carried away, but compared with other asset classes at least, fundamental valuation metrics suggest bricks and mortar are not the stupidest things to buy right now.