Equity Valuation and Portfolio Management

KEY POINTS

• Valuation multiples exhibit both cyclical and lower frequency fluctuations.
• Some of the key drivers of the P/E multiple are interest rates, the equity risk premium, the payout ratio, and long term earnings growth.
• The equity markets in the United States, continental Europe, and the United Kingdom have historically moved in cycles, each consisting of four phases.
• On the path from the through to the peak of the market nearly all earnings growth occurs in the Growth phase on average, whereas only −1%, 28%, and 3% of the price return for the United States, continental Europe, and the United Kingdom respectively occurs in this phase.
• Between 32% and 59% of the return from through to peak occurs during the Hope phase despite its short duration and, typically declining earnings.
• There is variation in the performance of asset classes and investment styles across these phases.
• The market implied equity risk premium varies over time in a way that is tightly related to the output gaps of the economy at home and abroad.
• We recommend that valuation analysis should adjust for the state of the economic cycle.