Climbing higher than ever before can be scary. The S&P 500 index of U.S. stocks is only slightly below its record, while the Nasdaq Composite index also hit 6,000 for the first time on Tuesday. Looking down from these heights (which are above the 30-year-average equity valuations in Switzerland, the U.S. and the UK), some investors have been withdrawing funds from stock markets. Investors pulled $14.5 billion out of U.S. equities in the seven days between March 29 and April 5 based on EPFR Global data, the largest weekly exodus since September 2015.
We nonetheless see a positive case for equities, and hold overweight positions in global and U.S. stocks against U.S. government bonds. Improved investor risk appetite after the first round of the French elections should also support growth-sensitive assets.
1) Record highs do not mean the market has peaked: A common behavioral bias can lead investors to "anchor" on a recent record, and assume it will be difficult for stocks to advance beyond it. But historical data suggests that record highs need not be market peaks, and that staying invested pays off. In fact S&P 500 figures from the past half-century show the market has returned an average of 4.6 percent in the six months after hitting an all-time high, compared to an average of 3.6 percent over the whole sample period.
2) Economic good news justifies high valuations. Valuation measures mean little in isolation from the macroeconomic context, and stocks are typically worth more during times of robust economic growth, low unemployment and moderate inflation. Trailing price/ earnings (P/E) ratios for the S&P 500 Index have averaged 19.9 times earnings in the months since 1960 that feature the lowest 10 percent of readings for the U.S. economic misery index (the sum of the jobless and inflation rates). Today the misery measure stands at 7.2 percent while the S&P 500's trailing P/E of 19.4 times earnings is in line with its average valuation when the misery index rests in a 7.1–7.7 percent range. We expect U.S. first-quarter earnings season to confirm that firmer economic activity is feeding through into solid earnings growth. In fact the expected 12 percent year-on-year rate we're looking for in the first quarter should be the best quarterly result in nearly six years.
Leading indicators of global economic growth also imply further gains for global stocks. According to Goldman Sachs, the MSCI World Index has generated an average 12-month return in excess of 10 percent since 1990, when global composite purchasing managers' indexes have climbed year over year. As of March this sentiment gauge was up 2.4 points, which bodes well for economic and earnings growth. And with valuations trading 1 percent below the 30-year MSCI World Index average, we believe the global equity rally still has room to run.
3) Above-average valuations don't mean a bear market is looming. Richer valuations need not necessarily weigh on subsequent six-month returns. Current trailing P/E ratios for U.S. stocks are consistent with subsequent six-month returns averaging 6 percent. Longer-term valuation measures using smoothed earnings over a decade (such as the Shiller P/E) do suggest that current valuations of 25–27 times earnings have historically led to average five-year total returns of 4.5 percent. That does not necessarily imply that investors should sell down U.S. stocks on a five-year time horizon. It does speak, though, to diversifying into global equity markets (where prospective returns look more appealing since cycle-adjusted valuations for developed and emerging markets alike are trading below their three-decade averages, according to data from Citi).
4) Equities remain good value relative to other asset classes, especially government bonds. Comparing stocks to other asset classes makes just as much sense as contrasting U.S. stock valuations to global ones. A yardstick for their relative appeal over government bonds, the equity risk premium for U.S., European, Japanese, and developed markets, stands at least one standard deviation above its long-term average.
Commentary by Mark Haefele, global chief investment officer at UBS Wealth Management, overseeing the investment strategy for $2 trillion in invested assets. Follow him on Twitter @UBS_CIO and on LinkedIn at www.linkedin.com/in/markhaefele.
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