The dizzying ascent of US stocks dominated news flow last year. The four main US stock barometers have touched a series of record highs, and concerns among investors about ostensibly lofty valuations have prompted many to offload US equities. In doing so, they have risked a significant opportunity cost – Michael Russell, Portfolio Manager, US All Cap, at Hermes Investment Management explains why.
The S&P Equal Weight Index (EWI) - the equal-weighted version of the widely-used S&P 500 index – has ranked among the top performing equity indices, in terms of returns, over the past 17 years. Returns generated by the index during that period were more than double those produced by European or Asian equity markets. And since hitting a nadir during the global financial crisis, the S&P EWI has surged by 368%.
Figure 1: S&P Equal Weight Index bounce back
Source: Bloomberg as at November 2017
However, investors are shunning US equities in favour of their international counterparts. In fact, capital has consistently flowed out of US equities and into international stock markets over the last 20 years. Data from the ICI showed that annual net outflows from domestic equity funds totalled almost $250bn in 2016. Investors shifting out of US equities are seeking diversification and better risk-adjusted returns. Furthermore, many believe they are too expensive. But we disagree, here’s why:
- The US economy is the largest and most dynamic economy in the world. It offers a supportive environment for entrepreneurs, particularly in places such as Silicon Valley, a world leader in innovation and a technological hub. Furthermore, the much-vaunted idea of the ‘American Dream’ has created a risk-taking mind-set and an entrepreneurial culture. As many as 700,000 new companies are created every year. These new businesses can generate up to 4m new jobs, helping job creation rates recover to pre-recession levels. However, there are also a number of company closures, which lead to job losses.
The revival of entrepreneurship is reflected in the high return on equity (ROE) of the US stock market, which is around 14% compared to 10% in Europe and Asia. The US economy is robust too. Europe’s ROE has been little changed over the last 10 years, while the US has seen its ROE rebound from the global financial crisis in just two years.
- Historically, the cyclically adjusted price-to-earnings (CAPE) metric – a valuation measure usually applied to broad equity indices - has produced inconsistent results.
Many bearish market commentators believe this metric suggests that the market is grossly overvalued at its current P/E ratio of about 30x. However, investors using this metric as a sell signal in the past would have missed out on the last three US bull markets. Only two bear markets have ever occurred at the same time as a peak in the CAPE, in the late ‘60s and the 2000s.
Furthermore, the CAPE metric fails to factor in the benign credit backdrop and the changing nature of the US market. Today, US-listed companies are more profitable and the technology sector accounts for the largest weighting in the market since the end of the dotcom era. Stock prices can rise faster than the CAPE as the recession years roll off the 10 year back period as well.
Figure 2: The CAPE ratio has produced inconsistent results in the past
Source: Robert Shiller, Yale University as at November 2017
- The correlation between price-earnings (P/E) and the subsequent 12-month performance of US equities is low. This is not surprising. In general, the equity market does not falter because prices become too high. Rather, the P/E is more likely to peak due to a decline in earnings as the economy falls into recession. For example, the last time CAPE was above 30x earnings was in 1997 – notably, the market doubled between 1997 and 2000.
 Source: Bloomberg as at November 2017
 Note: a log scale is used to depict the large percentage movement of the S&P EWI over an 18-year period
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