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Stocks Still Have Some Room to Grow


By Vadim Zlotnikov

Stocks have been on a pretty strong run in recent years, and some investors are nervous that the market could run out of steam. We think there’s still more upside potential.

After a lengthy, multi-year rally, equity indices have nearly tripled from their low point of March 2009. The S&P 500 Index has posted six straight years of positive yearly returns—five of them well into double digits. Investors are becoming increasingly worried about the possibility of a near-term market correction and low returns ahead.

Not Much Evidence of a Bubble

From a long-term perspective, traditional valuation metrics for developed-market equities seem more or less neutral today (Display), although they vary regionally. US stocks, for example, are trading at the very high end of their historical valuation range.

Still, we don’t see much evidence of a bubble in equities, such as companies aggressively steering capital into low-return-potential investments. We do expect more modest returns going forward, but there are cases to be made against a more pessimistic view—and even an overly optimistic view.

As we look out on the horizon, there’s a wide range of potential outcomes for equity returns. An annualized return of around 6% over the next 10 years would fall somewhere in the middle of that range of outcomes. That return would be lower than a “typical” equity return of 9%.

How might this type of scenario play out? Lower inflation and lower corporate earnings growth would play a role in driving below-normal equity returns—but not the biggest role. The primary driver would be normalization in the relationship among economic growth, corporate profitability and interest rates.

The way we see it, this would translate to valuation multiples staying about the same, with earnings growth decelerating and growth in nominal gross domestic product slowing down. Some of the potential developments in this scenario seem to align with our assessment. Profitability, for example, certainly could recede somewhat—net margins are, after all, 30% above their historical average.

Assessing More Extreme Potential Outcomes

But what about the potential for a more pessimistic scenario—one that might see a bigger mean reversion in corporate net margins that could put the brakes on earnings growth for years?

We think this scenario is unlikely, because operating margins aren’t exactly exorbitant globally. In fact, they’re only modestly above historical average. And much of the margin improvement has been structural, coming from lower taxes, lower interest payments and reduced depreciation expense. In our view, a significant increase in corporate excesses and investment would be needed to drive margin erosion.

There are highly optimistic upside scenarios, too, in which real interest rates stay historically low, profitability remains steady and capital use remains disciplined, with high payouts to investors continuing. We think these scenarios are unlikely, too. There’s not much precedent for real interest rates remaining persistently negative, which would be required to drive a substantially higher upside.

Modest Upside Potential Remains

All in all, we think the market today is either fairly valued or undervalued by 10% to 20%. The specific amount depends on how much central banks continue with quantitative easing and driving extremely low interest rates. So, evaluating the possible big-picture scenarios, we’d put a stake in the ground for the prospect of modest additional equity upside based on sustainable profit growth but steadily rising interest rates.

As for specific areas of opportunity in equity markets, we think high-dividend-yielding equities in Europe and dividend-growth stocks in Japan are attractive. We also see relative growth (growth at a reasonable price, or GARP) as an effective approach in the US. In Europe and Japan, we feel that exposure to value and income makes sense. Elsewhere in Asia, we’d suggest a defensive stance, until there’s improvement in earnings revisions and profitability trends.

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