Will Extended Valuations Lead To A Big Meltdown?

An equity market meltdown is unlikely if central banks act according to market expectations.

- Seeiso Matlanyane

The big topic in equity markets, particularly in the US where stock markets continue to reach new highs, is whether extended valuations are signalling that a big meltdown is in the offing. Trying to predict the future is exceptionally difficult, particularly at a time like this when Covid-19 has taken the markets into uncharted territory. The safest and easiest answer would probably be yes, because based on recent market history there has been a meaningful correction every 10 to 20 years or so. Unfortunately, it is not that easy; the remarkably strong price action that we have witnessed recently does not necessarily mean a meltdown is coming anytime soon.

The key concern for investors seems to be the perceived overvaluation of equity markets, which have had an exceptionally strong run since last March. Adding to that, markets had already had a strong run leading up to the pandemic. With the massive government and central bank stimulus programmes underpinning economies and financial markets, equity markets have managed to recover to levels before Covid-19 struck, and more. The concern is therefore whether stock prices have outpaced their earnings potential and therefore multiples are unsustainably high.

When these multiples are simply compared to their historical values, it is true that these are elevated. However, there are other things that need to be considered when assessing what the outlook for the equity market is likely to be and then making a call. These include financial conditions, market sentiment, behavioural biases, and earnings quality, among others.