Ofelia Marín-Lozano (1962 Capital SICAV) | It is said that stock market investment has to be analysed from a long term perspective. For a manager, the long terms begins from 10 years. For the investor, periods longer than one year, especially when returns are negative, start to become the long term.
To establish a consensus between both visions, in the market it is common to accept as long term any period which exceeds an intermediary point between the two perspectives, for example five years. Let us see what has happened in Eurozone financial markets in the last five years.
a) Interest rates paid on 10 year sovereign bonds, which are considered “risk free rate”, were the following in December 2013: Germany: 1.9%, Spain: 4.2%. In December 2018 they were significantly lower (Germany 0.2% and Spain 1.5%). In other words, the risk shy investor had guaranteed returns of the order of two percentage points above what he would obtain today.
If we take as the reference point bonds linked to inflation, we have moved from positive real returns to negative ones.
Five years ago risk free investment offered real positive returns, both in the German and Spanish market. Now it does not. The fixed return pais five yeasr ago was, on average, 2% more in real terms than today.
b) The stock market is trading at lower levels today, in absolute terms, in index points, than five years ago. Specifically, the Euro Stoxx 50 closed 2013 at 3.109 points, 3% higher than it closed 2018. Company profits have increased significantly in the last five years. Profits measured in Euro Stoxx 50 points (weighting for stock market capitalisation the 50 companies that compose it) have increased 64% (10.4% compound annual growth), from 136 to 223 points.
c) The earnings yield ratio (inverse of the PER) differential of the Euro Stoxx 50 and the real returns on sovereign bonds (taking the average between German and Spanish 10 year bonds), a good indicator of the of the stock market risk premium, has increased significantly.
The Euro Stoxx 50 earnings yield ratio has increased from 4.4% in 2013 to 7.4% in 2018 (or, seen another way, the PER has fallen from 23 to 13 times. On the other hand, the real returns on bonds (average between Spanish and German) has fallen from 1.5% to -0.8% in the same period. Thus the differential between the two figures has increased from 3% (4.4% – 1.4%) in 2013 to 8.2% in 2018 (7.4% – 0.6%).
In 2018 the stock market is offering an earnings yield ratio 5 points in real terms above that offered by sovereign bonds compared to what it was offering in 2013. In five years interest rates have lowered to historic lows, profits have increased more than 60% and stock market prices are down. The factor that reconciles these three elements (prices, interest rates and profits) is known in the market as the risk premium. And this, in the case of Eurozone stock markets, has almost tripled: from 3 to more than 8 points in real terms.
Have the risks of companies listed in the Eurozone really increased? Were there not more doubts five years ago than today, when the national budgets of periphery countries, like Spain, have returned to a certain balance? Is there no evidence that the global economy has incorporated tens of millions of new consumers in this period? Are bank balance sheets not healthier after a long period containing loans and increasing capital?
Yes, there is Trump, Salvini, May, Jinping… Five years ago there were other political figures in the frontline and, in another five years there will be others. But the recent punishment of the stock markets has led to abnormally low valuations. In the end reality will impose itself, and greater profits and dividends will end up being followed by higher prices.