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Has a bear market begun in equities? A framework for assessing scenarios

By 7 February 2022August 7th, 2022Commentary5 min read
  • Multiple compression in equities appears to have started.
  • The more expensive the asset or the index, the more vulnerable.
  • This suggests a cautious outlook may be appropriate for the US equity market.
  • For Europe the message appears more nuanced.
  • Parts of the market are expensive and so may be vulnerable, parts are not.
  • Despite a challenging set-up for passive and growth exposure to European equities, we remain optimistic about the absolute and relative returns for the LF Lightman European Fund in 2022.

What started as a sell-off in ultra-high valuation securities in 2021 has extended into broader parts of the equity market in 2022. Given equities have seen significant multiple expansion in the ultra-low interest rate and quantitative easing era, it is logical that as QE ends and interest rates rise, multiple compression could begin.

In order to assess downside scenarios it can be helpful to split indices into cheap versus expensive and see where valuations are compared to history.

Below we show a series for European value equities going back to 1995. The chart shows a composite valuation that incorporates both price to book and price to sales ratios. As usual we show the mean average and include standard deviation bands either side.

What is comforting is despite ultra-low interest rates, valuations for European value equities are almost exactly at the 25 year average. It is hard to make the case for downside here unless interest rates move significantly higher. The average level of German 10 year yields over the last 25 years is 2.9%. At the time of writing, German 10 year yields are 21 basis points. Perhaps if yields jump a further 200 basis points there may be a case for some downside for European value equities. But that is obviously a large margin of safety.


MSCI Europe Value Composite Valuation
Price to Sales & Price to Book 1995 – 2022

For European growth equities the picture is very different. Valuations are at +2 standard deviations from the 25 year average. A return to the mean valuation would imply 35% downside in absolute terms. Of course interest rates are still very low and so there remains a case for valuations to stay high. But the direction of travel is clear, higher interest rates will likely mean lower prices.


MSCI Europe Growth Composite Valuation
Price to Sales & Price to Book 1995 – 2022

In the US valuations are more extended across the entire market. Even US value equities are expensive relative to history, with 29% downside for US value relative to the 25 year average.


MSCI USA Value Composite Valuation
Price to Sales & Price to Book 1995 – 2022

US equity growth valuations are enormously and historically expensive. In recent months the composite valuation moved above the peak of the dotcom bubble. Even after the recent sell-off valuations are at 11x book and over 6x sales. There is no room for error here and 53% downside to the 25 year mean.


MSCI USA Growth Composite Valuation
Price to Sales & Price to Book 1995 – 2022

The combination of relatively expensive value and growth equities leaves the outlook for US equities as challenging. There are few hiding places if interest rates are to rise. It appears sensible to expect US equity market underperformance versus the rest of the world. We assume European equities will outperform US equities in 2022 and probably for some years beyond.

The counter argument to the above is that these valuation related points could have been made many times in recent years and they would have been wrong. Valuations were extended in 2019 yet they continued to rise. But the difference between that period and now was the existence of record quantitative easing and ultra-low interest rates. QE was the fuel for these record valuations and this fuel kept being poured into the market. But not anymore – the fuel is running out. Inflation is forcing central banks to change tack radically. The end of quantitative easing and rising interest rates is a new era for markets. Excessive valuations in all asset classes are likely to come back to earth.

The bar chart below summarises the charts shown above. To repeat, these downside scenarios are based on a return to the mean valuation of the last 25 years. The catalyst for declines of this magnitude would probably require significantly higher rates: German 10 year yields at perhaps 2.9% and US 10 year yields at 3.7%. These levels are also obviously not precise, as we know the market is not as mechanical as this, but these are the logical drivers and levels to have in mind to assist decision making.


% Change to 25 Year Average Valuation
Price to Sales & Price to Book Composite

Below is a chart of absolute valuations today for these categories. US equities are double the price of Europe in both value and growth indices.


Current Valuations for European & US
Value & Growth Equities

  • We have performed this analysis for some other equity markets and there is some good news here.
  • Not only does European value look like a safe harbour for client money in 2022, but also UK and Japanese value appear relatively cheap, as do parts of Emerging Market value.

Whilst we are expecting stormy conditions in markets in 2022 we believe the LF Lightman European Fund is prepared. The fund’s median PE ratio is estimated at 9.4 in 2022 and 9.1 in 2023. The fund has a median 2022 price to sales ratio of 1.03 and a price to book ratio of 1.01. Our holdings have record balance sheet strength. The expected dividend yield of the fund this year is 4.46%. Our base case is the European equity index may have more downside led by expensive securities, but we anticipate the LF Lightman European Fund being able to withstand this – and deliver positive absolute and relative returns in 2022.

MSCI, Bloomberg, Lightman