US equity valuations are the most attractive they have been for decades. But will cooling conditions mean investors are in for a nasty surprise?
After surging from market lows last year, the US equity market has become fixated on the possibility of an economic relapse.
A strengthening dollar threatens the translation of overseas profits for US firms and also reduces the attractiveness of US sourced products. Anxiety that started in Greece sovereign debt has quickly spread to a number of countries across Europe.
Direct exposure to Greece is limited but the market has become wary of the argument that the problem is small and contained after a similar line of reasoning was used to minimise the risk of sub-prime mortgages in the US.
Given global economy growth is dependent on strong economic growth from China, recent deceleration in loan growth as well as fears over a slowing overall Chinese economy have weighed on equities around the globe. To cap off the list of investor fears, the oil spill in the Gulf of Mexico hit portions of the energy sector hard and reminded the market of the potential severity of company-specific risks.
Expectations
These global macro negative data points did not mesh well with already high profit expectations. As the worst of the economic meltdown faded, the equity market was quick to adopt optimistic forecasts that combined cyclically rebounding revenues levering off smaller expense bases that were slashed during the recession.
Clearly, the market had been aggressive in raising expectations for cyclical companies as evident in the return on equity and net profit margins implied by 2010 profit estimates that had profitability back to prior peak levels. This is most acute in the technology sector where net profit margins for 2010 are expected to be over 25% higher than prior peak levels.
The unwinding of the optimism has also been evident in cyclical earnings revisions that are starting to slow dramatically in relation to more defensive companies. The pendulum has swung from domestic recovery optimism to anxiety imported from other parts of the world.
Housing
The US housing market has a few bright spots such as recent increases in the S&P Case Shiller Home Price Index in April after the preceding two months of declines. These glimmers are offset by the fact that home sales and new home starts have dropped off significantly after the end of the $8,000 first time home buyer tax credit deadline passed.
This fall off in demand has increased the supply of homes back up to around nine months, a level rarely seen over the past 20 years. The decline in demand ignored mortgage interest rates that have fallen well below 5% for 30-year fixed rate loans. This only highlights the extent that stimulus is responsible for much of the economic rebound experienced thus far.
Despite the relaxation in bank lending criteria, new loan demand is modest at best. This is not for lack of debt capacity on behalf of corporations but due to uncertainty regarding the level of economic activity. On the consumer side, new household debt growth has plunged but this has only dropped the measure of household debt to GDP modestly off record highs. The apprehensive consumer has also been dogged by 9.7% unemployment, suggesting that consumer spending that has historically been a large driver of economic growth will remain in low gear.
Inflation has been one source of comfort for the capital markets as the core consumer price index rose only 0.1% in May and core producer prices were up only 0.2% in the same month. Unemployment just under 10% and capacity utilisation in the low 70% range indicates that inflationary pressures are likely to remain modest.
Concerns
Aside from the traditional economic concerns, the US equity market has become concerned about the impact of large scale legislation on both the financial services and health care sectors.
Equity investors that bought stocks to play a “clarity trade” post the passage of legislation have been punished. The financial services reform bill has already driven one large US bank to announce that just one element of the 2,300 page bill could reduce revenues as much as $2bn annually, and this before the bill has been officially signed into law.
So many elements of this landmark legislation will rely on studies yet to be conducted and specific rules left to regulatory bodies that the final passage will only provide the market with limited clarity on the bill’s impact. Yet to be decided is capital requirements for banks.
This will be a significant driver to determine if these institutions with more constraints on revenue generation will be able to earn adequate returns for equity investors. Unfortunately capital levels require some consistency on a global basis requiring cross border collaboration in setting the standards. This harmony of regulation will only serve to lengthen the process of setting the ground rules that US equity investors need.
Ingredients
While equity market performance recently has been largely driven by macro factors, the ingredients are present for an individual stockpicker’s market. The forward price to earning ratio of the stocks in the S&P 500 with the highest anticipated long-term growth rate and the group with the lowest has converged significantly since the latter half of 2009.
This lack of a growth premium may or may not be justified but it does provide greater opportunities for individual stock selection. For investors willing to ferret out misunderstood companies, the industrial and consumer discretionary sectors offer numerous opportunities.
These numerous sources of anxiety are reflected in equity valuations. The dividend yield of the S&P 500 as it relates to the 10-year treasury yield indicates equities are the most attractive they have been in decades excluding the 2009 lows.
On a more simplistic price to earning measure, the S&P 500 index is trading at less than 13x and 11x estimated 2010 and 2011 earnings, which from an historical perspective appears cheap. The valuation of US equities invites investors to jump in but cooling conditions increase the chance for an unpleasant surprise.
Jeff Morris is head of US equities of Standard Life Investments
