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US Equity Valuations - Extreme?

Summary View

S&P 500 vs FTSE World x-USGlobal equity markets delivered unusually strong returns in 2019, and particularly so in the case of US equities. This has pushed the valuation of US equities to levels that have only been reached or exceeded on five previous occasions in the past 140 years covering the period 1881 to 2019. On four of those occasions returns over the subsequent 5-10 years were between -2.3% and +2.8% compound per annum and substantially below the long-term average returns (of 9-10% per annum).

In one respect, however, this time is different. US long-term interest rates at 1.8% are significantly below where they were at some other major valuation peaks; for example, in 1929 US long-term interest rates were 3.39% and in late 1999 they were 6.28%.

It's rising interest rates and/or tightening monetary policy that usually end equity bull markets. But there are scant signs of inflation and the Federal Reserve (US Central Bank) has signalled that it is likely to be tolerant of some inflation, so that there appears to be little likelihood of any rise in long-term interest rates in the US for some time to come. This bull market could continue.

On the other hand, corporate earnings are cyclical, and that applies equally to the in-favour tech sector, so that even without a tightening in monetary policy a temporary decline in earnings at some stage would be normal and would most likely puncture this bull market.

Both the price-to-10-year average earnings ratio and the equity/bond risk premium approaches to valuing US equities point to low single-digit annual returns from here on a 5-10 year view. And given that growth in S&P 500 Index earnings have been boosted by a reduction in the corporate tax rate (from circa 45% in 1970 to 21% today) and, more recently, by share buy-backs funded with debt, looking forward we doubt that the rate of earnings growth on the S&P 500 can match that of the past (6.6% compound per annum since 1970).

Our concerns regarding high US equity market valuations are not shared by other investors at this point in time. After all, Dow Theory for the 21st Century, a 120-year old technical indicator, remains in 'Buy' mode and suggesting that the primary trend remains upwards. Nonetheless, history is hardly bunk, and argues for much lower returns from here on a 5-10 year view. In addition, the risks appear to be to the downside given that the benefits of low interest rates, which are unlikely to be a permanent condition, have probably already been priced into the US equity market.

What to do? If you can't take a 5-10 year view as of today, then consider lightening up on your exposure to the broad US equity market, perhaps investing elsewhere if there is better value on offer. This message is probably most relevant to any investor approaching retirement age and who will be relying on his/her assets for their income in retirement.

The full article is best from via the attached PDF as the necessary charts and tables are easier to format and present and they are critical to the facts backing up the arguments. By clicking on the PDF you can continue to read online or you can download it to your own pc and/or print it out.

Are US Equity Market Valuations at an Extreme? (628.8 KB)Are US Equity Market Valuations at an Extreme? (628.8 KB)

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Rory Gillen
Founder, GillenMarkets

21st January 2020