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Are shares still good value?
After such strong equity market gains, it is time to consider reducing exposure, writes Mike Deverell of Equilibrium Asset Management.
‘Be fearful when others are greedy and greedy when others are fearful.’
This quote from Warren Buffett sums up the contrarian approach to investing. To ensure you buy low and sell high, you must think about buying when others are selling and selling when they’re buying.
Markets are generally at their lowest when sentiment is at its worst. By contrast, they peak when sentiment is at its highest. Market sentiment appears to be verging on the euphoric right now. This makes me worry.
After ending 2012 at 5,897, the FTSE 100 climbed to 6,347 by close on 1 February, an increase of over 400 points or more than 7.5% in a single month.
At Equilibrium, we have been overweight equities for some time and positive on this asset class. After such a strong rise, now is the time for us to re-test our assumptions and decide if we need to reduce exposure and bank some gains, or keep enjoying the ride.
In my previous Citywire articles, one constant theme I’ve returned to is valuation. How cheap does the equity market look based on earnings and dividends, for example? Is the valuation argument still so compelling as it was a few months ago, or should we be looking to reduce equities?
Looking at the UK market overall, the price/earnings (p/e) ratio is now around 13.2. This is based on historic earnings, those reported by UK companies over the past twelve months. A p/e ratio is simply the price of a share divided by its ‘Earnings per Share’. The lower the ratio, the (potentially) cheaper the stock or market.
On this basis, the UK market is trading slightly below its long term average of around 14. If earnings remained the same, the market would have to rise around 6% to revert to average.
Looking at other markets, both Europe and the US are now trading marginally above their respective long term averages on an historic p/e basis – they are therefore potentially overvalued.
Of course this ignores one crucial factor – earnings growth. We can also look at the p/e based on predicted earnings, known as the forward p/e. On this basis, the major markets are somewhere between 12% and 17% below their long term averages, provided those earnings forecasts are met.
That, of course, is a big ‘if’.
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