Is the equity market really overvalued? This one bank isn't convinced

A lot of people are worried that equities are overvalued.

But Saxo Bank thinks equity valuations have finally reached normality, and rising stock prices are now "solely dependent" on revenue and earnings growth. Head of equity strategy Peter Garnry explains why:

Equity valuations have normalised

Global equities, says Garnry, are still a bit below the average observed since 1996.

(Saxo Bank)

A z-score of 0 means the score is the same as the mean. The z-score is currently minus 0.14, which indicates that valuation has now normalised.

This means that global growth which drives revenue and earnings will now have to deliver for indices to carry on going higher. As to whether this is possible, Garnry says:

The JPM Global Manufacturing PMI index has increased almost continuously since August 2012 and since April 2013 the index has accelerated, indicating that the global economy will pick up speed over the next six months. As a result, revenue should begin to accelerate as well.

But the S&P 500 is overvalued?

Last year's bull run has left many analysts wondering if US stocks have gone too far.

(Saxo Bank)

Since early June 2012, multiple expansion - the rise in the price-earnings ratio of a stock or group of stocks - has pushed up total return to an impressive 32.4 per cent, in spite of more subdued earnings and revenue growth.

The multiple expansion is done for now in the US, despite rising stock prices relfecting expectations of an improving economy.

Like global equities, US stocks will likely slow down this year and increase more on par with the underlying growth in earnings and revenue.

There's still equity outperformance

The equity risk premium line shows the excess return that either an individual stock provides over a risk-free rate - usually that on longer-term government bonds.

(Saxo Bank)

Garnry says that it shows equities will continue to outperform bonds, but the gap is narrowing - and fast.

Improving economic activity in the US will mean increasing equity values this year, with rising interest rates pushing down bond prices - and that'll close the gap.