The world’s economic powerhouse is forging ahead, but has that left US equities overpriced? As the world waits for the Federal Reserve’s much-anticipated rate rise, Lynn Strongin Dodds takes a closer look.
The economic prospects across the Atlantic may look promising, but the time to buy US equities was in the summer, when prices plummeted by 10% thanks to a Shanghai Stock Exchange in freefall and a devalued renminbi.
The pickings aren’t that rich today as many stocks have regained their lustre and opinion is divided as to whether investors should look discerningly or turn their attention fully to Europe and Japan which offer more appealing possibilities.
There is no doubt that valuations in the US are lofty whatever metric is employed. Shiller, which is based on the cyclically adjusted price-to-earnings ratio (CAPE), that averages P/E ratios over typically 10 years, showed the most divergence. Trading at around 26, it is significantly higher than the historical average of 16.
The most popular – the S&P 500 ratio which is calculated by dividing stock price by earnings per share – is sitting on 16 to 17 x 2016 earnings which is slightly over the 14 to 15 x historical average.
The S&P 500 has also slowly recovered, erasing the 12.4% drop experienced during the August slump and is currently hovering back near the key 2100 level. While concerns over China’s sluggish economy and low commodity prices persist, the market received a fillip from better-than-expected third-quarter earnings as well as the continued stimulus from central bankers around the globe.
The new high though is not welcomed by everyone and some see it as a red flag to an overheated market. “The S&P 500 is now back above 2000, where it has been for most of the year but there was a six week period in the summer where it dropped and long term investors were able to embrace the volatility and commit new capital,” says Edward Perkin, chief equity investment officer at Eaton Vance Management.
“Much of that excitement is gone and we are back to a low volatility environment until we get another piece of news such as the Fed raising interest rates or China’s economic reports or another catalyst. In the meantime, we are in defensive mode and like branded food or tobacco companies.”
Jeremy Beckwith, director of manager research, UK at Morningstar agrees. “It does not offer many attractions,” he adds.
“Cyclically adjusted as well as median P/E ratios are near their highs and we are in the world of small numbers with regard to growth. The real economy is growing at 2%-3% but when you factor in near-zero inflation as well, nominal growth is very weak. The low growth environment is discouraging companies from investing in their future such as new plant or equipment.
“Instead, they want to keep shareholders happy and are doing buybacks or increasing dividends. However, this is doing little for economic growth.”
In fact, studies show that there have been bonanza pay-outs over the past year with a record $520bn of share purchases and $365bn of dividends. The combined $885bn not only outstripped corporate America’s total net income of $847bn, but surged relative to investment in the business.
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