The current valuation of equities raises eyebrows for part of the investor community, as they think it is too expensive. Since the trough in 2009, the global price earnings ratio has risen by a lofty 80% from 9.3 times trailing earnings to 16.7 times. Both Europe and the US now trade at a 15% to 20%-premium to their long-term average. However, we do not share the concern that equities are too expensive. Our conclusion is supported by fundamental as well as behavioural reasons. What drives valuations? 

## Multiple expansion precedes earnings growth


Source: Bloomberg, ING IM (July 2014)

## The first driver of valuations: the earnings cycle

When earnings trough, investors are willing to attach a higher multiple to these earnings in anticipation of a recovery (and vice versa). This is the phase during which the market is driven by multiple expansion and the periods 2008-2010 and 2012-2014 are good examples of this.

## The second driver of valuations: the monetary cycle

The second driver is the monetary cycle. Abundant liquidity drives earnings multiples higher. So, when investors expect that the monetary authorities are about to tighten policy, they are less willing to pay ever higher valuations. The relation runs through two channels. The first channel is the fear for lower earnings growth following tighter policy. The second one is the higher discount rate investors apply to future dividend streams.

## The third driver of valuations: the trend in perceived risks

The third driver is the trend in perceived risks coupled with the price investors are charging to take on this risk in their portfolio, the so-called required risk premium. Of course, risks reside in every corner of the spectrum but over the past years systemic, economic and geopolitical risks made the headlines. Systemic risks have certainly come down in developed markets, although in China they have probably risen. In Europe, all skies are not clear yet but a breakdown of the Eurozone is evaded and large imbalances between core and peripheral countries are fading. 

The improvement in the global cyclical indicators reduces the economic risks and hopes are running high that central banks will manage to cope with deflation risk. Geopolitical risks are present as always but recent developments in the Ukraine move into the right direction. Up until now the unrest in the Middle-East has had no significant impact on oil prices. So, overall in our view risks have come down.

## The final driver of valuations: relative valuation

In the Eurozone the dividend yield exceeds the Investment Grade bond yield and there is scope for these dividends to grow by at least 8% this and next year. Yield starved investors are increasingly looking to other sources of revenues. This is visible in the good performance of real estate and utilities. Outside the financial sector corporates are re-leveraging and the fast rise in Merger & Acquisition-deals are more favourable to shareholders than to debt holders. 

## We continue to prefer equities in Eurozone and Japan

The European earnings cycle is only about to turn positive and monetary policy will, if anything, become more loose. This implies that the European market performance can come from 2 sources: higher earnings and multiple expansion. In Japan relative valuation multiples have fallen close to record low levels and expectations on both structural reforms and monetary policy do not run high. Thus, there is scope for a rerating driven by a lower risk perception.