The Global Stock Market Decompression

Posted: Feb 05, 2021 1:10 PM
The Global Stock Market Decompression

Source: AP Photo/Richard Drew

In the most recent quarter, global stock markets continued to reverse the valuation compression which occurred in the first quarter.

In the first quarter of the year, during the worst of the COVID crisis, global markets collapsed in value. What that means is that prices of stock indexes went down faster than earnings. The most common way to measure valuation is called a P/E Ratio. It's the price of the stock (or of a collection of stocks, such as all the stocks in a country's market), divided by the last 12 months of earnings. When prices are dropping faster than earnings, that's called valuation "compression." When prices rise faster than earnings, that's called valuation "expansion." Compression and expansion are changes in the price that are not driven by changes in the earnings of the market. A valuation approach sees this compression, this lowering of valuation, as attractive. It's as though earnings are "on sale" compared to times when valuation has expanded and prices are high relative to earnings.

Last year was the story of very rapid compression in the first quarter, and very rapid expansion in the last quarter. Picture global stocks as a gigantic rubber ball. Market panic squeezed the ball in the beginning of the year and then by the end, as the panic wore off, the ball was able to expand back to normal.

Let's look at the data. Below you see two maps. On the left is the performance of all the stock markets in the world which we track in our universe. The color coding is: Red = negative return; yellow = zero or near zero return; green = positive return. The various hues of red and green show the varying relative size of the losses or gains.

What you can see is that it was a good quarter for global stocks. They all gave a positive return.

The map on the right shows the change in valuation, that is, the change in the price relative to the earnings. Red/orange = less attractive valued (expansion); green = more attractively valued (compression).

It was generally an expansionary quarter. Of the 42 countries shown here, only five got more “on sale”. The rest got more “marked up."

The scatter chart below the two maps shows the story a slightly different way. It compares each country's return (the up and down axis) to that same country's change in valuation (the left to right axis). Moving right is more attractive. That line is called a "regression line," it shows the relationship between the two factors. This one tilts downward, which means they negatively correlate.

So, the general story is that the countries which performed best in returns tended to do so by becoming less attractively valued and vice versa, which was the opposite of the general pattern in the first quarter of the year. Over time, valuations tend to gravitate back towards normal and this year was not an exception: The panic compression in the beginning of the year, reversed by expansion at the end of the year.