A notable aspect of equity markets over the past two years has been the absolute and relative strength of developed equity markets. This newfound strength has come to reverse years of distinct underperformance compared to emerging markets, including the JSE.
In the figure below, we compare the performance of the S&P 500 to the MSCI Emerging Market (EM) Index, the benchmark emerging market index and the JSE All Share Index, converted to US dollars since 2000. As the chart shows, the very good relative performance of the S&P 500 is a very recent development. We consider whether these recent trends in relative performance can be sustained.
It should be noted that the JSE in US dollars has outperformed not only developed equity markets since 2000 but has also performed better than even the strongly performing MSCI EM Index that accords about an 8% weight to its SA component (the MSCI EM does not include JSE-listed companies with a primary listing elsewhere).
Relative performance: The S&P 500 vs the MSCI EM vs the JSE (in US dollars, 1 January 2013 = 1)
Source: I-Net Bridge and Investec Wealth & Investment
For the year to the end of June, the S&P 500 was up about 12.6% while the MSCI EM Index had lost 10.9% of its 1 January value and the JSE in US dollars was down about 14.2% (see below). The JSE in US dollars usually behaves very much like your average EM market, for good fundamental economic reasons as we will demonstrate. It has suffered an extra degree of rand weakness against the US dollar, compared to other EM currencies, and so the JSE in US dollars has lagged behind its EM peers.
The S&P 500 vs MSCI EM vs JSE (January 2013 = 100), daily data, US dollars
Source: I-Net Bridge and Investec Wealth & Investment
We can provide a good economic rather than sentiment-driven explanation for this recent outperformance by the S&P 500. We show below how S&P 500 earnings and dividends per share have moved higher since 2011 – while EM and JSE earnings have declined from their recent peaks.
We also show that the growth in EM earnings and JSE earnings in US dollars have been significantly negative – but appear to be coming less negative, while S&P dividends per share have remained positive, though may be trending lower. We provide a time series forecast of both series to mid 2014. Bottom up estimates of S&P 500 company earnings as well as an extrapolation of recent aggregate trends indicate that S&P earnings and dividends will rise further over the next 12 months from their current record levels. The time series forecasts of EM and JSE earnings also point higher, but only well into 2014.
Index earnings and dividends per share in US dollars (2000 = 100)
Source: I-Net Bridge and Investec Wealth & Investment
The earnings and dividend cycles (2010-2014)
Source: I-Net Bridge and Investec Wealth & Investment
Not only have the S&P 500-listed companies performed better than their EM rivals, but we would also suggest that the S&P 500-listed companies have delivered better than expected bottom lines while EM equities and the JSE have delivered disappointing earnings. We will use our valuation models to make this point.
We use S&P 500 dividends rather than earnings as our measure of the economic performance of the S&P 500 because of the complete collapse of earnings in 2008-09. This extraordinary decline in earnings largely reflected the impact of the Global Financial Crisis on the earnings of financial institutions that had to write off so much of their failed lending books. The decline in S&P 500 dividends was less severe and can be regarded as more reflective of the underlying economic conditions.
Our valuation models can be described as earnings or dividend discount models. We run a linear regression equation to explain the level of the respective indexes. We use the level of reported earnings or dividends and long term interest rates as explanations. The models reveal a highly significant positive and consistent relationship over time between the index and earnings or dividends and a negative relationship with interest rates, just as basic valuation theory would predict. These models can be regarded as price to earnings (PE) or dividend ratio predictors of the market levels, with these multiples adjusted for by the prevailing level of long term interest rates. These interest rates represent the rate at which earnings are presumed to be discounted to establish the present value of reported earnings. The long term interest rate acts in the model as a proxy for the required returns of equity investors, or the opportunity cost of capital.
The dividend or earnings discount models do a very good statistical job predicting the value of the different indexes, as we show below. When however market values, as predicted by the model, exceed current market values (i.e. the model suggests an overvalued index), we can describe the level of the market as being demandingly valued and vice versa as undemandingly valued, when the current level of a market is well below its predicted value. These predictions are based on past performance.
When a market is demandingly valued, that is when current market values are well above predicted or “fair value” according to the model, it is so because earnings are expected to grow strongly and vice versa. Subsequent events will either confirm or refute these optimistic predictions. If earnings do grow as strongly as expected, the index will be supported. If earnings disappoint, the index is very likely to fall away to fall in line with lower earnings. Similarly, when the index seems undemandingly valued – that is, it stands well below its value as predicted by the model – then this may well be confirmed by subsequently poor reported earnings. Then, if earnings subsequently turn out stronger than expectations, share prices and the index will gather strength. The degree to which the predicted values fall above or below predicted values – indicating optimism or pessimism about the economic and earnings outlook – may also be regarded as a measure of risk aversion or risk tolerance.
The observer may then wish to take issue with the collective consensus views that are revealed by market prices. The market might be thought to be too optimistic about the outlook for earnings – too risk tolerant in other words. This would encourage the sceptical active investor to reduce exposure to equities. Or, if the market is judged too pessimistic, or too risk averse by an active portfolio manager, this would encourage a greater exposure to risky equities in the view that economic events and growth in earnings, will turn out stronger than the market expects.
The predictive power of this approach can be back tested by using the models. This will show whether the signals provided by the model to buy or sell more equities would have been justified by subsequent market moves.
Such a model of the S&P 500 run in October 2010 – using data going back to 1980 – would have suggested a deeply undervalued, risk averse market at that time (understandably so with the memory of the global crisis still very fresh in the memory). The degree of undervaluation was of the order of 50%. In other words, the S&P 500 was 50% weaker than would have been predicted, on the basis of the relationship till then between earnings, interest rates and the market. The same approach would have revealed an especially very overvalued or risk tolerant market in early 2000 – just before the Dot.com bubble burst.
Using the same valuation method for the JSE, with all variables measured in US dollars, and using the difference between RSA and US long term rates as the interest rate influence on valuations, the JSE in October 2010 appeared as significantly, or some 28%, overvalued. Subsequent strength in the S&P 500 and weakness in the JSE, when measured in US dollars, provide good support for the validity of the dividend discount model.
The JSE vs the S&P 500, US dollar values (2011- 2013)
Source: I-Net Bridge and Investec Wealth & Investment
We do not have index levels and index earnings data for emerging markets that go back to 1980. However a model of the MSCI EM, using monthly data estimated for the period 1997 to 2010, provides very good statistical fits and estimates. This indicates that emerging markets were fairly valued (not over or undervalued) in late 2010 as per the predictions of the earnings discount model.
For discount rates in this model we have used the spread on EM bonds. It would seem that investors in EM equities in late 2010 were anticipating further increases in earnings from the average EM company. That this performance did not materialize was surely disappointing to investors, leading to a decline in the EM equity markets. By contrast, the subsequent strength of S&P 500 earnings, given its undemanding valuations of that time, early in 2011, was surprisingly good and able to lift the S&P 500 higher.
Updating the model and drawing conclusions about relative performance of developed and emerging markets
We can apply the same approach to the equity markets today. According to the dividend discount model, the S&P 500 today, supported by strong dividend flows, is still significantly undervalued for reported dividends adjusted for long term interest rates, judged by past performance. The model suggests fair value for the S&P 500 as almost 2500 compared to the 1630 levels prevailing recently.
The market and predicted value of the S&P 500, using the dividend discount model
Source: I-Net Bridge and Investec Wealth & Investment
The JSE measured in US dollars in June 2013 remains overvalued by about 22%, according to the model. Applying the model of the JSE measured in rands and using long term interest rates as the discount factor however, suggests that the JSE is not much more than fairly valued. The earnings discount model applied to the EM Index also suggests that this market is in fair value territory.
Thus one can conclude, with the aid of the earnings or dividend discount models, that the markets today are in a similar state to that of early 2011. The S&P 500 valuations appear still undemanding, while the emerging markets are in something like an equilibrium “fair value” state. On this basis, the S&P 500 and developed markets in general would seem much more defensive than the emerging markets and the JSE: the emerging markets remain more dependent on a good recovery in earnings than the S&P 500. Yet the outlook for earnings growth seems more promising in the developed than the emerging world – with the latter’s greater dependence on resource producing companies.
The state of the global economy will depend to an important degree on the future state of the US and Chinese economies. The developed markets will take their cue mostly from the US and the emerging markets mostly from China. One could say the same about commodity prices and the economies more dependent on them. Yet strength in the US, still a very large part of the global economy, will provide impetus to growth everywhere else including in Europe. The most direct beneficiaries of faster US growth will be the companies listed on the S&P 500. In a way it might also be said that China depends more on the US than the other way round.
Lower commodity prices reflect more subdued growth in China and expectations of growth there. However lower commodity prices, while harmful to the commodity producing economies, Australia, Brazil and SA among others, are very helpful to consumers everywhere and especially in the developed economies that account for much of consumer demand. This divergence would apply even more were the oil price also to give way, more than it has to date, to slower growth in China.
The conclusion one is inclined to come to is that, in the absence of a resurgence of growth in China and the other BRICs, and given the positioning of the different markets, the best value in equity markets over the next 12 months may well still be found in the developed rather than the emerging market space.
The realisation of these higher values will be threatened by abruptly higher movements in long term interest rates, of the kind that roiled all markets after the last meeting of the Fed. Faster economic growth in the US will lead to higher interest rates in due course. But faster growth means faster growth in earnings. This may be more than sufficient to overcome higher interest and discount rates in the market valuations attached to the companies delivering these higher earnings and dividends.
