by Russ Koesterich

How to find value in today’s market

BlackRock June 2013 Market Perspectives

BlackRock June 2013 Market Perspectives
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A few years ago – even last summer – talk of another equity market bubble would have seemed premature, if not absurd. But now that global equities have risen approximately 25% in dollar terms from last June through late April, the question on many investors’ minds is: Are we in a bubble?

Despite the recent market surge, we are not in a bubble, according to BlackRock’s chief investment strategist Russ Koesterich. In the latest BlackRock Market Perspectives, Koesterich argues that most markets today are trading at or below their long-term average.

US large cap stocks are trading at roughly 13x next year’s price-to-earnings. Small caps are somewhat more stretched, with the Russell 2000 trading at more than 16x next year’s earnings – but Koesterich says few segments of the small cap market appear to be out of bounds.

Trailing earnings suggest a similar conclusion, he says. The S&P 500 was trading at roughly 15.25x trailing earnings in late April, compared with average and median multiples of roughly 16.3 and 16.5 respectively over the last 60 years.

Looking at book value, US stocks are trading at roughly 2.3x book compared with 3x book value at the last market peak in the fall 2007 and more than 5x book at the height of the bubble in late 2009. The MSCI ex-US Index of developing countries is trading at a significant discount to its average since 1995 at around 1.5 x book value, and the emerging market countries are at barely 1.4x book.

But Koesterich warns that reasonable valuations, particularly in the United States, are a function of record high profit margins that are likely to revert back to their long-term average. While equities are still likely to outperform bonds, Koesterich says they are unlikely to produce the consistent double-digit returns that historically have been the result of lower valuations.

Koesterich’s approach: Conditional value

To evaluate opportunities in these markets, Koesterich takes into account broad macroeconomic fundamentals that have historically driven value – an approach he calls “looking at conditional value”. Broad macroeconomic trends are generally well-priced, whether looking at individual companies, sectors and country level aggregates, according to this approach.

To the extent market valuations deviate from levels that can be justified by fundamentals, these 'mispricings' will eventually revert. Countries or sectors where prevailing macroeconomic conditions cannot explain high valuations are expected to underperform the broad market over time. Market segments where valuations do not appear to fully account for an asset’s fundamentals relative to its own history and other market segments are expected to outperform.

What’s cheap today: Buy risk, sell safety

Koesterich’s methodology reveals that, in some instances, investors are paying too much for safety or growth. 'Safe' countries trading at a premium today relative to their own history include Germany, Switzerland and the US while 'fast growth' regions such as Philippines, Peru, Indonesia – and to some extent Mexico – are trading at a premium relative to their peers.

Countries in the 'global bargain bin' are primarily the larger emerging markets that have fallen out of favour, including China, Brazil and Russia – but not India. While all these countries face significant challenges, those appear to be discounted in the price, says Koesterich. Some northern European nations such as Austria and Denmark as well as South America, Hong Kong and Taiwan all score well on the conditional valuation metrics.

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