Should you dump equities?

High-quality equities are expensive. That’s something we’ve been telling you for a while now (although we haven’t been entirely sure what we should all do about it). A note out from one of our favourite analysts, Andrew Lapthorne at Société Générale confirms the extent of the problem.

Thanks to the generally weak fundamentals across the board, the pool of higher quality assets has become more limited in the last few years. And if you try and screen the remaining ones by some kind of valuation filter, not much comes up.

Lapthorne has used a 4% dividend yield, and in doing so finds that “the percentage of companies passing such a screen dwindles to historically low levels.” So, “high quality equities are not only harder to find, but they are more expensive.” This throws up so many problems it is hard to know where to start. But here are a few.

When quality stocks are expensive in this way, their absolute returns over the next 12 months tend to be weaker than those of other types of stock. That suggests you shouldn’t hold them. But this is only the case if the market holds up. If it ‘corrects’, the higher quality assets are likely to produce the “best one-year relative performance as weaker and lower quality assets fall further.” That suggests you should only hold them if you think the market is going to fall, but you aren’t sure enough to get out of the market all together.

Is the market going to fall? Lapthorne has one more bit of performance evidence to chuck into the mix here: “historically, a lack of quality income opportunities has been a bad omen for future equity market returns.” He backs this up with a nice chart (that I will ask for permission to reproduce below later) looking at the size of the quality income universe against market returns one year out. It doesn’t make you want to hold many equities at all.