ALLURE OF STOCKS REFLECTS GREAT EXPECTATIONS / THE FINANCIAL TIMES OP EDITORIAL

Allure of US stocks reflects great expectations

Investors are keen to jump in, anticipating strong outlooks, but caution is warranted

Michael Mackenzie



When stock investors chase after winners, it is striking how often they end up in the US.

All of the top five stocks in the FTSE All World index by market weight are US tech giants, so it is no surprise that over the past decade, Wall Street has eclipsed rivals, driven by big tech and other leading multinationals.

That remains the story for 2019. So far this year, the All World index excluding the US has risen around 9 per cent. Throw in the S&P 500, and the gain moves towards 15 per cent.

Not surprisingly, broad valuation measures of US equities are elevated. Not only that, but they sit well above rivals, such as those for Europe, the UK and emerging markets. The cyclically adjusted price/earnings multiple, known as CAPE, for the S&P 500 currently trades around 29 times, compared to a historical mean of 17.

In contrast, across other equity markets, the CAPE ratio is far lower. That suggests that investors with an eye on valuations and long-term returns should think seriously about areas of Europe, emerging markets and even the UK, which has been harshly downgraded within many portfolios since Brexit erupted.

Daniel Grosvenor, equity strategist at Oxford Economics highlights how the CAPE on the MSCI All Country World Index of 19 times represents “a near record gap” with the S&P 500.

“The US is also where valuations are currently most stretched . . . and it is also the epicentre of our concerns on corporate leverage given the prevalence of share buybacks in recent years,” he warns.

Where does this huge lead for the US come from? It could be that US companies are simply far better at reaping revenues and controlling costs. Aside from the obvious disrupters in the technology sector, Wall Street has gained a great deal from an integrated world economy, which helps multinational companies reduce labour costs, alongside low interest rates and competitive tax codes.

Potentially helping US markets further, the past 18 months of trade friction between the US and China may soon become a touch smoother. A slowing global economy has weighed on corporate profits growth alongside business and consumer confidence, even for the S&P 500.

Keeping the show on the road have been central banks, easing policy rates at their fastest pace since the financial crisis era, while government bond yields are substantially lower since January, providing a valuation crutch for equities and credit.

This has also offset the prospect of an S&P 500 earnings recession for the first time since 2015/2016. Next week, the latest quarterly earnings season starts, led by financials unveiling their results and talking about their business prospects for 2020. This represents an important period for investors as companies at this stage of the year are in a better position to outline how things look beyond January.

Wall Street is relying on upbeat tidings from executives; the fact that the S&P 500 is just shy of its record peak in July reflects expectations of a rebound in activity during 2020. Much of the rise in equity prices since January amounts to a down payment that future earnings growth accelerates. That is why analysts still pencil in S&P 500 earnings growth in the region of 10 per cent for both 2020 and 2021.

The problem is that we have been here before; 12 months ago, for example, analysts expected that S&P 500 earnings would expand by 10 per cent in 2019. Now the market expects a 2 per cent growth pace in earnings for all of the year, with upcoming third-quarter results at this juncture seen contracting when compared to the same period a year ago.

For all the optimism that S&P 500 earnings growth will pick up speed, there is a considerable warning flag fluttering over Wall Street in the form of the recent revision for US whole economy profits, known as the National Income and Product Account, which covers the universe of US companies from small to large.

Anastasios Avgeriou at BCA Research notes that this measure “peaked in advance of SPX earnings in the previous three cycles”. That now appears to be the case again when looking at NIPA profits and profit margins. It is also highlighted by this year’s lagging performance of midsized and smaller US companies.

‘’Economy-wide profits may have already peaked this cycle, warning that the S&P 500 earnings juggernaut is long in the tooth,’’ says Mr Avgeriou.

The heavyweight technology sector, a longstanding winner, has long propped up US large-caps, but history tells us that rotations eventually clip the wings of the largest and expensive areas of the market.

As Rob Arnott at Research Affiliates told a conference in London this week, “the largest stocks in the market are often expensive and have historically underperformed over the next decade.’’

Global equities face earnings fatigue but much lower valuations outside of the S&P 500 provides a degree of insulation and a better long-term starting point that favours Emerging Markets and in particular beaten-down value shares.