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A Note on US Equity Valuations

Summary View
US equities have advanced uninterrupted for almost two years straight, and the valuation of the market is now expensive relative to history. In the past, buying US equities at current valuations has generally led to poor subsequent returns as measured on a 10-year view.

The bullish case is that current low short- and long-term interest rates should persist for a time yet and that, in a recovering economy, corporate earnings can continue to grow and can bring values back to more acceptable levels.

The bearish case is that a recovering economy will surely lead to a turn in the interest rate cycle and that bank deposits and long-dated government bonds offering higher income will better compete for investors' monies. In addition, US corporate earnings appear to be already far ahead of long-term norms and are more likely to decline from here than rise further.

Our own view is that the risk to earnings and a likely turn in the interest rate cycle outweigh the bullish arguments, and we are not buyers of US equities save the defensive global consumer franchise stocks and Berkshire Hathaway.

The Bull Case for US Equities
Central Bank Intervention
As we stand today, official interest rates at three major central banks stand at record low levels. The Federal Reserve has its official lending rate at 0.25%, the Bank of England at 0.5% and the European Central Bank 0.15%. On top of this, central banks have been actively buying back bonds on the open market and the increased demand from this quantitative easing has pushed up bond prices and yields down to the extent that long-term interest rates are well below 3% in the US, UK and Ireland, and well below 2% in Germany.

When interest rates are low, a natural corollary of this is that equity (share) prices increase: currently, there is little value on offer in government bonds or cash deposits, which is pushing investors to buy into equities (where the earning yield and dividend yield are higher). If, or when, central banks decide to raise official interest rates, and halt their buying of bonds on the open market, equity prices are susceptible to declines if investors can find better or competing value on offer in bonds and cash deposits.

The bullish argument resulting from the above analysis is this: that equity valuations may be overextended, but this is justified by the level of interest rates. This phenomenon is known as a 'rational bubble'. Bulls who make this argument state that, while the bubble has to pop eventually, one can still ride the wave until stronger evidence of a turn (upwards) in the interest rate cycle is seen. The question that one might pose - but to which we do not have the answer - is whether long-term interest rates can stay low enough for long enough to provide time for corporate earnings to grow ad lower current equity values sufficiently to justify current share prices.

While no investor may have the answer to this question, it is true that the market is still full of bulls: a large portion of institutional investors in the US are aware that equity valuations have reached high levels, but are still willing to invest in equities, either because they think less value is on offer elsewhere, or because they think that interest rates will stay low for some time. A bull market ends when selling gains the upper hand over buying; thus, as long as this buying power is still in place, the odds of an end to the bull market remain low.

Returns are Worse Elsewhere
The argument here is that the outlook for future returns for equities may be dim in the future, but the outlook for most of the other main asset classes is even worse. For example, the current yield to maturity on 10-year US government bonds is 2.5%; inflation is currently running at 2.1% in the US, so the real return that these bonds are paying you is 0.4%. The outlook is even dimmer for cash deposits. Even junk bonds, which are supposed to offer higher yields in order to compensate investors for the higher credit risk, offer yields that are very low relative to history.

Owning equities may be the most rational alternative: investors may not do well in equities, but they will do better.

The Bear Case for Equities
An end to the current bull market in US equities could happen in one of two ways: investors could change their mind on the multiple they are willing to pay for each dollar of earnings (a change in the price-to-earnings ratio), or earnings could fall back to more normal levels. We have written extensively about both of these possibilities.

A Rerating of the Price-to-Earnings Ratio
CAPE Ratio v 10-Year Return

We have talked previously about Robert Shiller's cyclically adjusted price-to-earnings (CAPE) ratio, and how it can be used to measure valuation in equity markets.

The CAPE ratio divides share prices by the average of the past ten years' earnings, as this smoothes out the business cycle troughs and peaks in earnings. Thanks to Shiller, we have this data going back to the 19th century.

A useful guide to future potential equity returns can be found by comparing historic CAPE ratios with the subsequent ten-year returns that investors earned.

This is exactly what the chart on the right shows us. On the left-hand axis is the CAPE ratio of the S&P 500 from 1930 onwards. The axis is inverted, so the higher values are lower down. On the right-hand axis are the rolling ten-year total returns that were earned by investors over the next ten years. For example, in 2000 the S&P 500 was trading on a CAPE ratio of 43.8 times; if an investor had bought into the S&P 500 at that point, he/she would have earned a negative 0.8% compound per annum over the next ten years.

A quick glance at the chart is revealing: it can be seen that, the higher the CAPE ratio, the lower the subsequent returns. In fact, the two figures seem to follow each other in lockstep, and there is a strong (negative) correlation between how the market is valued and subsequent returns.

The red circles on the chart highlight periods of overvaluation in the S&P 500 relative to the long-term average. These periods occurred in 1929, 1966, 1995, 2000, 2006 and 2014. It is instructive to look at the compound per annum returns earned by investors if they had invested at each of these points and held for ten years:

Year CAPE Ratio Date Reached 10-Year C.P.A. Return
1929 32.6x Sep 1929 -4.3%
1966 24.1x Jan 1966 +4.4%
1995 25.0x Dec 1995 +9.1%
2000 43.8x Jan 2000 -0.8%
2006 27.3x Dec 2006 5.0%*

* An eight-year period

It should be noted that the above returns were generated before inflation, and would be significantly worse if inflation were accounted for. In both 1930 and 2000, subsequent ten-year returns were negative. In 1966 and 2006 (although only eight years have passed since the 2006 market top), returns were both below the long-term average returns from equity markets of 9-10%. Only in 1995 were the subsequent ten-year returns in line with the long-term average.

For 2014, the CAPE ratio stands at 26 times, once again well above the long-term average of 15 times. If history is our guide, the returns on a 10-year view from here are likely to be poor, and it is from this analysis that we get our cautious stance on US equities.

Earnings Reverting to the Mean
Profits v GDP

Higher interest rates can lead investors to demand a higher earnings yield in equities and, in order for the earnings yield to rise, share prices have to fall. This is the same as investors paying a lower price-to-earnings ratio for a given level of S&P 500 earnings. In addition, a bear market in equities can also occur if investors believe the underlying earnings are going to decline due to recession or other factors.

Today, US corporate earnings as a percentage of GDP are at a peak compared to history. Historically, after-tax corporate earnings have accounted for 6.5% of GDP; currently, after-tax corporate earnings account for 11.2% of GDP, which is a significant deviation away from the normal level. Technological advances have made corporate America more profitable and US companies are generating a greater percentage of their earnings from overseas compared to history, both of which support the argument that US earnings as a percentage of GDP are now permanently higher.

However, against these more supportive arguments are the facts that record low interest rates and ongoing government fiscal deficits (over-spending) have probably boosted corporate earnings beyond their long-term trend.

On balance, we are more inclined to view US corporate margins as being above trend, and we would be cautious about the sustainability of US corporate earnings on a medium-term view.

This risk, of course, is largely captured in Shiller's price-to-10-year average earnings ratio (CAPE) - which is not dependent on current earnings but the averages of the last ten years' earnings - but the chart measuring after-tax corporate profits as a percentage of GDP highlights the risks to earnings more clearly.

What to do?
When we buy into markets, we try not to predict whether the trend of markets; instead we prefer to build up a portfolio that has a value bias which prevents us from overpaying for assets. Attempting to do this allows us to build an asset base that will deliver growth over time, regardless of the higher risk embedded in, say, the US equity market due to overvaluation.
For subscribers interested in investing in the US markets, this can mean buying buying into the US and European Global Consumer Franchise Stocks Theme or building up a holding in Berkshire Hathaway.

Rory Gillen is founder of GillenMarkets.com, the online investment website, and author of 3 Steps to Investment Success published in October 2012.