An equity rally - time to be discerning

Equity markets have rallied strongly over the first two months of 2023. Many stocks which sold off in 2022 have been in the vanguard of this rally.

However, there are different dynamics underpinning these moves and we would argue that investors need to be careful about the factors driving the rally in some stocks – it is a time for investors to be discerning.

Last year there were two broad themes causing stocks to de-rate. The first was a structural re-pricing of expensive equities in response to rising interest rates and higher bond yields. The second was a cyclical de-rating of real economy focused stocks due to recessionary fears and higher input costs, which were exacerbated by Russia’s invasion of Ukraine.

In Jan-Feb of 2023, stocks in the first category above have rebounded, in line with the expectation that central banks will stop raising interest rates, due to some moderation in the rate of inflation.

While those in the real economy basket have rallied in response to easing cyclical concerns: fears of a sharp recession have reduced, energy costs have rolled over, and Europe has survived winter (the pinch point of its energy security crisis) without blackouts.

For illustration, we take the NASDAQ as being representative of the first category and the DAX as a proxy for the second, real economy focused group.

The rally in both indices over the first two months of 2023 has been similar, with the NASDAQ gaining 9.4% and the DAX 9.3%, and this follows declines over 2022 of 25.2% and 7.4% respectively.

Table 1 – Performance 

Source: Bloomberg, 10 March 2023

However, over the five years up to the end of 2021 there was a marked divergence between the indices – with the NASDAQ gaining 165.1%, compared to a more modest 35.9% rise in the DAX.

Much of this five-year gain in the NASDAQ reflected a 52% re-rating in the valuation multiple from a P/E of 28.7x, at the end of 2016, to 42.1x, at the end of 2021. The gain in the DAX over the same period actually lagged earnings growth with its P/E de-rating by 7% from 15.1x to 14.1x.

Table 2 – P/E valuation multiple 

Source: Bloomberg, 10 March 2023

While the NASDAQ has de-rated somewhat since those end of 2021 levels, its P/E multiple of 32.7x at the end of Feb is still 14% higher than 2016. Conversely, the DAX has got even cheaper with its end Feb 2023 P/E of 11.7x being 23% lower than 2016.

In our view, most stocks in the expensive parts of the market didn’t de-rate enough over 2022, yet they have rallied on the expectation of a pivot in central bank policy.

We would be wary of chasing stocks that offer little value in the hope that they can re-rate further.

For us, the rally in stocks which offer the solid starting point of an attractive valuation, and have business models which are well-placed to drive earnings over the next cycle would appear to be built on stronger foundations.

As we have discussed before, not all equities are equal – and all rallies aren’t equal either!

Any views and opinions are those of the Fund Managers, and coverage of any assets held must be taken in context of the constitution of the fund and in no way reflect an investment recommendation.

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