Most equity measurements - from CAPE to earnings yield - suggest the US market is significantly overvalued. Geoff Legg, investment manager at Kennox Asset Management, explores the options for investors who still want exposure to the market
Last month, the S&P 500 reached a record high, following significant gains in March and April. While the US market underperformed European counterparts slightly in the first quarter of 2015, the outperformance of the market over the last 15 months has been astonishing. In sterling terms, it has risen 25% versus 7% in Europe, and zero in the UK (see table).
Given these trends, investors are faced with legitimate questions that have cropped up regularly in recent months: is the current US trend sustainable, and are US equities overvalued?
The answer to these questions will dictate how an investor approaches the US market. The tapering of quantitative easing and the increase in interest rates (the question being ‘when' rather than ‘if') have made the topic all the more pertinent.
Overvalued indicators
If it is believed the current US trend is sustainable, and that US equities are not overvalued, then broad (ie, indexed) exposure to the US is still a valid approach. If, on the other hand, an investor concludes the situation is unsustainable and equities are overvalued, then the US market should be approached cautiously via specific, appropriately valued opportunities. While arguments can be made from both sides, there are three indicators which suggest the US market is currently overvalued.
Firstly, cyclically adjusted P/E (CAPE). This measurement is widely recognised as an indicator of market valuation. The historical, long-run average of CAPE stands around 15x. In the lead up to the financial crisis it measured in the mid-40s. It currently stands at 30x, which is approximately 80% above its long-term geometric average.
Secondly, q. This measures the replacement value of companies (similar to a price-to-book value ratio) and it has shown to be consistent in its valuation of the stock market. It currently indicates the market, again when considered against its historical geometric average, is overvalued by approximately 80% (see graph).
Thirdly, earnings yield (the inverse of P/E) provides a good indicator of potential returns from the market. At current levels, the earnings yield on the S&P index is just over 5%. Many would argue this is an unacceptably low return for taking on risk associated with investing in equities.
The convergence of data - the cyclically adjusted CAPE and the replacement value of companies (q) - indicating the market is overvalued by about 80%, together with low earnings yield should give pause to investors considering the US.
Avoid US?
Is this to say the US should be avoided entirely? There are stocks that will produce reasonable returns in an overvalued environment but investors have to work harder to uncover those trading at acceptable valuations.
A good place to start the search is to locate those companies that are currently ‘unloved', which have not done so well in the short term. These may prove to offer excellent long-term opportunities if the underlying business is sound. A variation on this approach is to look for sectors or geographies that are unloved, and then search for the best quality companies within those areas - this allows an investor to combine quality with value.
Choosing exposure
It is also possible these upward trends will continue and there will not be any negative consequences as a result of rate rises and the beginning of the end of QE - what commentators have affectionately termed ‘taper tantrums'. In that case, investors are justified in taking an indexed exposure to the US market.
Investors sceptical of this view should consider taking a different course. High-alpha managers adept at discovering specific opportunities can provide the right type of exposure to an overvalued market.
If, and when, markets return to more normal valuations, investing in low cost index trackers will once again make sense. But that time is not now.
